“The dollar is our currency, but your problem”
– J. Connally, 1971
Sufficient evidence is the Figure 1, – ever since the collapse of the Bretton Woods, the USD has taken increasingly larger portion of the world’s balance sheet. On the other side of it – savers, with Japan and China topping the list of US Treasury debt holdings today. It’s them who worry about the US default most.
Figure 1. US Treasury debt ownership composition
What if – US default? With the USD holding a large liquidity premia (discount), with the panic spreading to global financial markets (even on just expectation) the USD should be bought. In particular, the “lower tier” G10 (from CAD to Scandies) and Emerging Market currencies (especially MXN) would suffer on widening liquidity premia (money destruction). And yet, I would argue the rebound of the USD against the major European currencies, if any, would probably be limited and temporary, while weakness against the JPY would be pronounced.
What makes this time different from Lehman-event? The starting point. Global world is flush with excess official liquidity, bank system has responded to the Lehman shock and is more robust now, central bank ‘put’ is hanging out there, killing any sign of volatility. The USD has not been on a weakening trend for a protracted period of time, in contrast to pre-2008, and the massive speculative short positions in USD had been built up among speculators then, in contrast to net longs now. Europeans are no longer as dependent on the USD liquidity (look at the EUR-USD basis, Figure 2), and the overall USD liquidity “gap” has been closed – if anything, the gap in the banking system has been a net positive since 2011, now in excess of USD 200bn (Figure 3).
Figure 2. EURUSD cross currency basis curve
Figure 3. USD global bank liquidity gap
Default or no default, the prospects of the USD are worsening with every day of the political drama. A postponement of the deadline or the US downgrade will make more difficult for the Fed to start exiting easy monetary policy – maybe even push to intervene with more QE in the worst case. Confidence will suffer, and will be reflected in worse economic data in the coming months (this risk – one of the reasons Nordea Markets has changed official forecasts for the USD last week, lifting the EURUSD profile a bit).
Most important question: how will the reserve managers respond? We have already seen large sales of US assets by foreigners earlier this year. According to the IMF’s survey of global reserve managers, policy level concerns are the key reason to trigger change in currency portfolio composition (Figure 4). Over the past few years, while the Europe was in the existential crisis, the diversification from the USD to EUR has been reversed (Figure 5). But now, with the US policy uncertainty running high, potential downgrade and other economic policy dilemmas (QE and tapering), it may well be the composition will be questioned again – this time, not in the USD favour.
Never say never (again).
Figure 5. Global currency reserve shares – EUR and USD
Nordea