USD Bulls: Stop Cheering

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USD short-term interest rates have increased relative to other currencies without helping the greenback.

USD can benefit only if long-term Treasury yields increase their difference from other developed economies’ currencies, which seems highly unlikely.

The risk of USD shortage, which could help the greenback to soar, can be alleviated by the activation of USD swap lines.

USD bulls are convinced that the dollar will rise, but they are running out of arguments to support their conviction. Those who base their optimism on the unwinding of the USD carry trades must know that such a scenario is highly unlikely for a number of reasons. Then there are those who have gone "all-in" on the prospect of a Fed interest rate hike, which will happen in the next few months, but it won't necessarily help the dollar reach new sustainable heights. It is important to understand that a random or arbitrary spike in the USD (NYSEARCA:UUP) price is not the same as a continued uptrend since the latter would demand consecutive rate hikes. How then can USD bulls be so optimistic?

One of their main arguments is that the interest rate differentials between the greenback and the rest of the reserve currencies will push the USD into a long-lasting appreciation. This will in turn make US interest-bearing assets more alluring, generating huge inflows to the dollar. Their optimism is also fueled by an imminent dollar shortage crisis that may occur due to the excessive amounts of dollars emerging market corporations have borrowed. Following the bull logic, an interest hike will cause investment demand for the greenback, leaving fewer dollars available for foreign borrowers to repay their USD loans. This equation will result to a dollar uptrend. While this argument seems compelling, it is rather simplistic as it relies on the very basic rules of economics i.e. supply and demand, and ignores the global macroeconomic complexities, which if analyzed might actually lead someone to a very different conclusion.

Interest Rate Differentials

While the difference in short-term interest rates, as indicated by the 3-month Libor rates, has been steadily increasing for the last couple of years it has not assisted the USD to rise. In other words, the rising short-term USD rates have proved to be completely uncorrelated with the USD price so far. Even though bulls are banking on an increased demand for dollars, believing that such a demand will increase its inflows, it's clear that's not the case. In fact, the three-month LIBOR rate difference between the dollar and the euro has grown by a staggering 0.95% in the last six quarters. The difference between the dollar and the sterling has grown by 0.72%, and by 0.52% with the Japanese yen. So the bulls are right, demand for the dollar is growing, it's just that its price won't move. The US dollar index has actually stayed trendless moving in the same area it had since Q1 of 2015 despite the fact that an interest rate hike did occur during this period.

USD Libor spreads

Source: St. Louis Fed

Without short-term rates affecting the USD price, the last leg left for bulls to stand on are the US long-term yields, which are perhaps a more decisive driver as to a sustained dollar trend. Indeed better US yields in relation to the other developed market currencies could grant the greenback a boost. However, for this to work, the USD long-term yields would have to rise faster than their developed counterparts, enticing global investors to switch to US Treasuries from other sovereign bonds. So far, this has not occurred. In fact, the difference between the 10-year US Treasury yield and that of 10-year bunds, as well as the 10-year JGBs has been stable for the last couple of years. Excluding the recent Brexit related turbulence caused between 10-year Treasuries and 10-year Gilts - the UK government bonds - the difference between the two has also remained steady, for the most part. Even during the Gilts craze where a frantic buying of UK bonds dragged their yields down, investors didn't seem to flock to the USD as a safe alternative because this buying spree proved to be short-lived. It did cause the difference between Treasuries and Gilts to spike from 0.4% to over 1% in just a couple of months, but recently this difference shrank to half, since fears about the UK's creditworthiness fueled a massive sell-off of Gilts, pushing their yields up again. So even in the face of such an extreme case, the US dollar didn't seem to benefit, and it couldn't have, since the yields of competing sovereign bonds followed US yields closely.





Unless the yield differential between US Treasuries and competitor bonds begins to trend higher, the greenback won't experience any investment inflows from abroad. For such inflows to begin, the US economy must manage to decouple and lead the global business cycle, a scenario which has a very low probability of occurring. Rather, the opposite mechanism seems to be the case. Demand from emerging economies fuels an oil related rally which shifts expectations for inflation across the globe and eventually in the US. Under such light, emerging market currencies are better positioned to benefit from the macro backdrop than the US dollar is, making the case of a generalized USD appreciation trend highly unlikely.

Risk of a Global USD Shortage

The last myth worth busting is the risk of a global USD shortage. As mentioned, bulls believe that the dollar is going to become scarce as a massive and global flight to the world's reserve currency will leave less of it to go around. International corporations have increased their exposure to the greenback, either through USD loans or through the issuance of USD-denominated bonds, due to the low cost of funding in relation to their domestic interest rates. This behavior has indeed formed excessive allocation of USD debt to various parts of the world. Recently, Bloomberg estimated that as of July, Turkish companies have amassed a $201 billion net FX shortfall in their balance sheets, which equals to almost 30% of the country's GDP. If the dollar begins to strengthen rapidly against the lira, Turkish companies, which get their lira-based revenues mainly from their domestic market, will struggle to service their USD obligations. While this is music to bull ears, they have not considered the reaction central banks would have in the face of such a FX nightmare.

Central banks are equipped with some powerful tools for dollar liquidity called USD swap lines. These swap lines were introduced by the Fed during the Great Recession and are still very much in place in case they need to be activated again. These liquidity tools are actual agreements between the Fed and each central bank which stipulate that the former can supply the latter with a fixed amount of dollars in exchange for its currency, and reverse the transaction in the future. Faced with a USD shortage, and considering how indebted their corporations are in USD loans, central banks will absolutely activate their swap lines in order to arm themselves and shield their economies. It is almost impossible to believe that central banks will let their economies drown just so the bull prophecy can come true.

It goes without saying that an activation of swap lines will most certainly increase the global supply of dollars, counteracting the excessive demand and inherently alleviating buying pressures on the greenback. So, the argument that the US dollar will soar because it will become scarce is just not true. In fact it might actually have the opposite effect i.e. swap lines might make it as abundant as it is today, if not more.

All these reasons heavily challenge the optimism of USD bulls. Carry trades don't seem to be unwinding; interest rates don't seem to matter at least in the short term, and long-term US yields don't seem capable of decoupling. Even a shortage in USD supply doesn't seem to provide a long-lasting impact, as it can easily be reversed. So what exactly are USD bulls so happy about?

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Additional disclosure: The views expressed in this article are solely those of the author, provided solely for informative purposes and in no case constitute investment advice.