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Market dislocations abound these days. Interest rates, equity and commodity markets were desperately trying to make sense of the disproportioned uncertainty as a result of the tragic Russia-Ukraine conflict.
The oil heavy Goldman Sachs Commodity index (US crude & Brent crude making up about 44%) closed at 783 points, up 20% over the week. Energy, base metals and soft commodities like wheat and corn moved up in sync. This index is exactly 100 points below the all-time high reached in September 2008, at 893 points. Back then, crude oil made reached high of USD 145.29 on July 3, 2008, before collapsing to a USD 33 low level by the end of a momentous year as the global economy went into a deep recessionary contraction.
The dollar index (a measure of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners’ currencies i.e. Euro, Japanese Yen, Sterling, Canadian USD, Swedish Kroner and Swiss Franc) reached a low of 71.32 in April 2008. Ever since then, the USD index has been trending higher. Over the past week, the USD index appreciated by 2.03% closing at 98.65.
In retrospect, 2008 was the peak of unfettered, unregulated globalisation. From that moment on, we have seen monetary authorities stepping in to dominate market functioning and assure liquidity provisioning, stabilising financial markets in lockstep. The seeds of deglobalisation were sown during the GFC.
The political confirmation of deglobalisation surfaced with the Trump US presidency between 2016 and 2020. The pandemic was unable to derail the USD ascent, notwithstanding aggressive asset purchases and zero-interest-rate policy by the FED. The pandemic did intensify deglobalisation, as inventory build-up, onshoring and vertical integration became the common-sense reaction across corporate boardrooms. The political class quickly took over this narrative in order to provide an answer to a discontented middle class and increase probabilities of re-election. The Russia-Ukraine war is accelerating this deglobalisation process and the agendas of the US, the EU, China, and Russia will turn even more inwards.
The narrative that the USD as a global reserve currency will be negatively affected by competition from the Chinese Yuan, gold or cryptocurrencies is missing some underlying currents. These underlying currents should inform participants that the USD is as strong as ever as a global reserve currency. The main fallacy is that the definition of the USD as global reserve currency has often been too narrow.
Participants point to the total of FX central bank reserves held globally. In that sense, we have effectively seen an overall drop in USD % holdings. On May 25, 2021, the IMF website reveals: “The share of US dollar reserves held by central banks fell to 59 percent—its lowest level in 25 years—during the fourth quarter of 2020, according to the IMF’s Currency Composition of Official Foreign Exchange Reserves (COFER) survey.” The latter account for about USD 12 to USD 13 trillion. However, including the private sector USD denominated transactions and liabilities we arrive at USD 170 billion. The often-used former global USD central bank reserve metric pales in comparison to the real FX USD exposures expressed by the latter figure. To be clear, in times of financial stress and typical USD strength, we do see that central banks might be selling US Treasuries in order to sell USD in the process to protect local currencies. But still, the USD strengthens as more dominant flows are at work. Having the status of reserve currency par excellence is achieved as the currency, the USD, represents all outstanding public (through official FX reserves) AND private liabilities that need to be honoured, across the financial system.
These private liabilities stack up as follows:
The private liabilities come in the shape of USD denominated certificates of deposits (CD’s), commercial paper (CP’s), large USD time deposits and repurchase agreements (repo). The Bank of International Settlements (BIS) tracks these outstanding on-balance sheet exposures across global active banking institutions. These cross-border bank liabilities sum up to about USD 32 trillion as per end 2020, of which almost half attributed to USD and about 30% to the Euro.
International debt securities make up the next batch of USD liabilities. This is known under the label of Eurobond markets. It has nothing to do with the Euro in particular, but encompasses the hard currency sovereign and corporate bonds outstanding across global reserves currencies. End of 2020, this sector totalled about $23 trillion of which about 45% is USD denominated. Since 2008, the share of the USD across international debt securities has risen from 30% to 45%. USD as an issuance currency has gained a lot of popularity over the past 14 years. Locating USD liabilities across countries is essential to detect potential USD demand surges. For example, the Russian corporate bond exposure sits at a USD 250 billion equivalent, of which about USD 90 billion is labelled in USD, about USD 15 billion in Euro and about half in Rouble. Announcing the demise of the USD as the global reserve currency of choice, by using the argument that the Russian central bank has sold its US Treasury holdings and lowered its overall USD exposure in favour of gold, is taking unsubstantiated shortcuts.
The over-the-counter (OTC) FX transactions, accounted for as derivatives, in USD through FX USD swaps and FX USD forwards make up about 65% of total FX transaction volume each day. These off-balance sheet USD transactions make up about 65% of total daily global FX volume, sitting between USD 6 and USD 7 trillion a day. By the end of 2020, the amount outstanding was about USD 98 trillion. 90% of these OTC FX markets run across USD.
If we combine all of the above USD demand vectors, we notice that the global reserve status of the USD has remained untouched over the past 30 years. Above ground total mined gold as per end of 2021 sits at around 205.240 tonnes. At current market value of USD 58.000 per kilogram, that adds up to an asset class worth almost USD 12 trillion. The market value of all crypto currencies combined sits currently around USD 1.75 trillion (about 1/100 of the USD liabilities summed up at USD 170 trillion from the above categories). Compared to the USD amounts outstanding above, it is a far cry from expecting gold and crypto currencies to challenge the leading role of the USD in the global financial system. If anything, the surge in gold might be a correct and clearer signal supporting the call that gold might take over from crypto as a proper flight to safety investment decision.
The title of this piece ‘Testing Parity’ refers to the possibility for the EURUSD to depreciate towards 1.00. It broke 1.10 last Friday and a test of parity might be in the offing. The USD might strengthen further:
if geopolitical tensions increase, pushing more investors towards the refuge currency of choice and more robust portfolio diversification.
if the FED tightens monetary policy more aggressively than the ECB.
if the FED does not fight USD appreciation as it would limit imported inflation and overall inflation pressures.
if the USD status as global reserve, funding and transaction currency remains undeterred given above argumentation.
if deglobalisation proves to be, on balance, a USD appreciating factor.