A weakening US dollar is still the preeminent currency

In early June, the U.S. dollar appeared to be in total free fall. From May 14 through June 8, the Bloomberg Dollar Spot Index tumbled 4.6%, effectively wiping out all of its appreciation during the worst of the coronavirus crisis. A Bloomberg Opinion column from Stephen Roach, former chairman of Morgan Stanley Asia, declared: “A Crash in the Dollar Is Coming.” He got a lot of pushback.

Depending on how you define a “crash,” it certainly looks as if the Yale University faculty member had the direction right. The Bloomberg dollar index is down an additional 3.7% since then, well below its moving averages and dangerously close to breaking through a key intraday level that could give traders scope to push it lower by at least 2% more. The four-year chart, which captures the ups and downs of the foreign-exchange market since President Donald Trump was elected, looks rather ominous:

Yet when evaluating the dollar on a 10-year time horizon, the greenback’s move over the past several months looks less like a crash and more like a simple unwind of the haven flows during the height of the Covid-19 pandemic, combined with a natural weakening given the Federal Reserve’s relatively more aggressive monetary policy response compared with its global central bank peers:

When thinking about the fate of the U.S. dollar, it’s crucial to separate an extended decline in the greenback’s exchange rate from the prospect of America losing its place as issuer of the world’s primary reserve currency. These are distinct outcomes with drastically different implications. The former is hardly unusual, given that the dollar has historically fluctuated in multiyear cycles since the early 1970s. The latter would represent a seismic shift in the structure of the global financial system.

Simply put, it’s in no country’s or region’s best interest (at least not imminently) for the U.S. dollar lose its place as the reserve currency of choice. That means the dollar will retain its place on the global stage no matter how weak it might get in the months to come. But make no mistake: There are any number of reasons to bet that the greenback will slide further.

Most obviously, the dollar tends to appreciate when U.S. interest rates climb and weaken when they fall. Short-term Treasury yields are pinned near zero and are expected to stay there for years, while longer-term yields have increased somewhat but remain near all-time lows. There’s also the well-known fact that the federal budget deficit has ballooned this year in response to the Covid-19 pandemic. Traders widely expect that large shortfalls will continue in the year ahead, particularly if the Democratic Party sweeps the White House and both chambers of Congress, as polls indicate.

Either way, America’s so-called twin deficits — in both its current account and budget — are so extreme that a regression analysis from Bloomberg News’s Cameron Crise projects a 31% decline over the next two years in the ICE U.S. Dollar Index, known as DXY. There’d certainly be no hyperbole in calling that a “crash.”

It’s hard to imagine that sort of precipitous decline happening, however, without an exogenous shock that’s separate and distinct from interest rates and deficits. My Bloomberg Opinion colleague Noah Smith posited last month that a complete breakdown in America’s institutions could be that force:

Urban chaos, violent conflict and uncertainty over who will control the country in the coming years make for a very bad business environment. In a worst-case scenario, businesses and investors could decide the U.S. is a failing state and that their money is best kept elsewhere, at least until things quiet down. The result could be an unprecedented capital flight — money stampeding out of one of the world’s largest economies and abandoning the reserve currency at the same time. That would probably mean a dollar crash, a surge of U.S. inflation and destabilizing flows of hot money into Europe, Japan, Canada, Australia, South Korea and other, more stable developed nations.

Suffice it to say, that sort of dystopian outlook probably shouldn’t be anyone’s base-case scenario for how the next few months will unfold in the foreign-exchange market. Indeed, speculative U.S. dollar traders recently turned positive on the greenback for the first time in four months, with net noncommercial positions in DXY futures rising above zero for the first time since June, according to Commodity Futures Trading Commission data. While that’s hardly a decidedly bullish position, it at least suggests a sizable pool of money will take the other side of the dollar doomsday narrative.

The most likely path for the dollar remains lower, though it stands to reason that traders want to get through the U.S. elections before going out on a limb. Both a “blue wave” and a contested presidency could send the greenback spiraling. Some, like Roach, would argue that another four years of a Trump administration and its protectionist trade policies and withdrawal from crucial global agreements would also erode the dollar’s value because the rest of the world sees America as an unreliable global leader. On the other hand, a clean Joe Biden victory combined with a Republican Senate and Democratic House could mean gridlock and comparatively tame budget deficits.

But even if the dollar falls 2%, 5% or even 20% more — which would put it near its post-2008 crisis low —  it’s not an existential threat as long as the greenback holds onto its “exorbitant privilege.” It’s not particularly close to giving that up, with International Monetary Fund data showing $6.8 trillion of FX reserves held in dollars compared with $2.2 trillion in euros, $625 billion in yen and $486 billion in pounds.

So don’t sweat the continued slide in the dollar too much. Whether considered weak or strong, it’s poised to remain the epicenter of the financial world for many years to come.