The US dollar conundrum

The US dollar conundrum

Good morning and welcome to today’s foreign exchange market commentary on Wednesday, the 6th of March.

Many economists believe the current monetary and fiscal policies of the US are unsustainable. The net debt, as a share of gross domestic product, has doubled in the last five years and is expected to rise further in the coming decade even if interest rates are normalised and the economy recovers fully. US debt will accelerate as the population ages and social benefit costs rise rapidly, pushing debt to more than 100 percent of GDP.

Similarly, the Federal Reserve’s asset purchase program has resulted in excess reserves with commercial banks, and at more than $2 trillion, has reached unprecedented levels. Consequently, real interest rates on 10-year Treasury notes have slumped to negative levels and even the Fed recognises that this needs to be reversed.

While the future consequences of these imbalances remain unclear, long-term interest rates may rise sharply and the dollar may depreciate substantially as foreign investors become increasingly reluctant to hold US debts. Domestic investors, wary about the unwinding of monetary and fiscal positions, might aggravate the situation further by shifting their assets to other countries.

Skeptics, however, tend to dismiss these concerns on the ground that the dollar is the world’s reserve currency and it carries fewer risks than other currencies. Both the arguments aren’t without flaws though.

Firstly, the foreign holdings of dollar-denominated securities are no longer primarily “foreign exchange” reserves in the traditional sense. Many large economies in Asia, including China, hold foreign reserves not with the intention of bridging external trade deficits. So the US no longer has the privilege of having its legal tender as the reserve currency.

Secondly, the argument that investors don’t want to hold assets denominated in other currencies is also false. Large portfolios diversify their holdings in different currencies and different asset classes. If dollar and dollar-denominated bonds are perceived as risky in future, the asset mix will change and demand for dollar will fall, resulting in the currency’s depreciation.

The dollar’s trade-weighted value has already fallen by more than 25 percent despite the contagion in Europe and elsewhere. Still, the US continues to run a large current-account deficit. The dollar may fall further if political gridlock over fiscal imbalances continues.


GBP/EURO – 1.1581
GBP/US$ – 1.5124
GBP/CHF – 1.4241
GBP/CAN$ – 1.5522
GBP/AUS$ – 1.4241
GBP/ZAR – 13.6405
GBP/JPY – 141.08
GBP/HKD – 11.7178
GBP/NZD – 1.8178
GBP/SEK – 9.6421

EUR: The shared-currency witnessed mixed fortune yesterday though overall sentiment towards the currency was negative due to concerns on the region’s economy in general. Following last night’s meeting of EU finance ministers, Ollie Rehn, the Economic Affairs Commissioner, signalled several countries will be granted more time to meet their budget deficit reduction targets. Countries like Portugal and Ireland may be given more time to return the funds borrowed at the height of the financial crisis. In short, Europe seems to be heading towards less fiscal austerity. The final iteration of the Eurozone’s services sector purchasing managers’ index came in at 47.9 from an earlier estimate of 47.3. Barring Spain, all of national gauges either beat or met economists’ expectations. The economic data calendar is light on the ground today and markets will wait for the ECB’s press conference tomorrow with expectations for a more positive tone.

USD: Sterling managed to add some points against the US dollar and the euro early yesterday after surprisingly strong Services PMI reading provided some respite from the recent dire construction and manufacturing numbers. The figure, best in five months, goes some way to alleviate worries of a Q1 contraction in the UK. Also, statistics showed retail sales increased by 2.7 percent in February, boosting confidence in the pound. However, the optimism was overdone and talks of further quantitative easing by the Bank of England on Thursday pushed the cable lower through the afternoon and the GBP/USD pair traded above the 1.510 level as traders seemed reluctant to push too hard. US non-manufacturing data also came in higher than expected at 56, well into expansion territory. The Dow Jones Industrial Average rose to an all-time high in response while the FTSE recovered to pre-Lehman levels. Today we have the ADP employment numbers from the US along with factory orders for January. The dollar is expected to remain stronger today.

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Have a great day!


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