The U.S. dollar is the world's reserve currency. Today, this means that it is the most coveted of all currencies per global central bank reserves (see chart below). While major financial institutions and investors naturally favor USD given that it is highly liquid, many important and popular commodities, such as gold and oil, are also priced in USD.
(Source: Bank of International Settlements. BIS data suggests major FX reserves favor USD in the region of 50%, while IMF data indicates that more than 60% of central bank reserves are denominated in USD.)
The recent decline in the value of the U.S. dollar has been rapid and, for many, unexpected. The chart below shows the recent decline in DXY, the U.S. dollar index.
(Chart created by the author using TradingView. The same applies to all subsequent candlestick charts presented hereafter.)
It is important to note that DXY heavily weights the euro; and EUR/USD has risen rapidly in recent times (see my recent article for more details). The decline coincides with a fall in U.S. equities, which has been equally surprising, although perhaps not for some; the threat of the coronavirus (the virus being SARS-CoV-2; the disease being COVID-19) has engendered an evidently significant de-risking among global investors.
The chart above illustrates two levels (see the horizontal black lines) which are 10% and 20% from all-time highs. Heuristically, traders consider a 10% draw-down as a correction; a 20% draw-down is considered a bear market. U.S. equities are currently in the middle of this area (having recently hit the midpoint of this crucial area).
Conventionally, when markets are not so volatile, traders would expect to see the U.S. dollar rise in line with falling equities (i.e., not fall together with equities). This is because when the dollar rises, equities appear cheaper in international FX terms. For example, if the euro strengthens (as it has done recently), U.S. equities suddenly appear cheaper, due to the euro's increased purchasing power. If USD strengthens, U.S. equities seem more expensive, and hence they are at greater risk of falling.
The recent drop in USD, coinciding with the major correction in U.S. equities, signals a major global risk-off move. Consider that the euro is a popular funding currency; many traders and investors have likely (or at least previously, until recently) sold the euro short. This is because the European Central Bank's comparable interest rate (which feeds through into FX brokerage rates) is negative -0.50%, making the euro highly liquid and profitable to short. These trades have been unwound, likely with plenty of margin calls in the case of leveraged trades, generating a precipitous rise in EUR FX crosses (at the expense of USD).
This kind of activity signals not just "risk-off," but also a high demand for cash. In the midst of a global pandemic (i.e., the coronavirus in this case), the safest thing to do is to sell everything and convert all international FX holdings into your domestic currency. This will be partly why EUR has strengthened so significantly against even USD (despite the negative interest rate differential), not because the euro is being safer but because European investors are returning to cash.
The recent rate cut has perhaps not helped things; the U.S. Federal Reserve cut its target short-term rate by 50 basis points in the first week of March. The interest rate differential remains positive, however, and furthermore, the U.S. dollar might not move in such an intuitive fashion upon a Fed rate cut. Consider the graph below, which shows how the U.S. dollar index (or DXY) has moved after Fed rate hikes in the past (in 1994, 1999 and 2004).
(Source: Pound Sterling Live)
You might expect USD to rise rather than fall, as surely a higher interest rate makes it more profitable to own the U.S. dollars (all else equal). The converse thought is also logical: if the Fed cuts, it should make USD less favorable to hold due to the lower interest rate, and hence USD should fall. So far, USD has fallen, but consider the reason why the Fed recently cut: to support the economy in the midst of a global economic shock (the coronavirus, which has recently led Italy to quarantine millions of people).
The virus is a global problem, not a North American problem, and hence USD is likely to become more in favor going forward. A reminder of Dollar Smile Theory (as illustrated simplistically below) would be befitting.
(Source: BabyPips)
Whether the U.S. cuts rates is less relevant than why it cuts rates. Per Dollar Smile Theory, USD is likely to weaken if the U.S. is economically weak relative to other countries. USD is likely to strengthen if the U.S. is economically strong relative to other countries. However, there is a third potential: if the U.S. is weak, while other major economies are also weak, USD strengthens on the back of its world-reserve-currency and safe-haven status.
The recent drop in the value of USD has been reactive. The risks in Europe, including not just in Italy but also France, Germany, Belgium and the Netherlands (among other European nations), could lead to reactive selling of EUR and buying of USD going forward.
The ECB has not yet taken significant action (in terms of either cutting rates further into negative territory, or introducing new stimulus measures). A significant economic contraction in Italy will likely lead to the spread between Italian and German bond yields to spike in the near term, as recession risks will begin to mount for Italy. This could also feed into panic-selling of EUR and EUR-denominated assets, and panic-buying of USD. It might even lead to large inflows into the U.S. equities, should the U.S. equity market manage to avert bear-market status.
The coronavirus threat will likely continue for the foreseeable future, although hopefully not beyond this year. Ideally, the virus will slow massively as weather conditions improve seasonally, giving the virus less conducive conditions for further spreading (i.e., higher temperatures, and higher or moderate humidity levels).
Yet we do not have to be optimistic on this front to favor USD. It is likely to be the safer place to park cash going forward. Europe was already a low-growth, low-inflation environment before the emergence of the coronavirus. With it, after the dust settles following the unwinding of carry trades and demand for cash, EUR/USD is likely to fall, and in this author's opinion, USD is likely to find renewed strength.
