/Currencies: The U.S. dollar refuses to stay down — here’s why

Currencies: The U.S. dollar refuses to stay down — here’s why

The U.S. dollar won’t stay down despite the Federal Reserve recently undertaking a number of actions that would be expected to weaken the currency, and instead it rose on Tuesday in a reflection of a continued scramble for the currency outside the U.S.

“There is still a tremendous amount of demand for USDs in the financial system that is squeezing the FX markets, and we are still in early days of the shut down of sectors of the economy around the globe,” said W. Brad Bechtel, global head of FX at Jefferies, in a note.

The ICE U.S. Dollar Index

DXY, +1.68%

 , a measure of the U.S. currency against six major rivals, was up 1.6% at 99.609, according to FactSet. The euro

EURUSD, -1.9318%

 plummeted nearly 2% to $1.0975, while the U.S. unit soared against the Japanese yen

USDJPY, +1.56%

 by 1.4% to ¥107.43.

On Monday the U.S. currency fell against its major rivals, including the euro and the Japanese yen after the Fed delivered a bazooka’s worth of policy stimulus and also moved in concert with other major central banks to ease the terms on dollars it provides to foreign central banks through dollar-swap lines that were put in place during the 2008 financial crisis, a move aimed at addressing a global scramble for dollars that was seen contributing to liquidity problems and tightening financial conditions in credit markets.

“With the U.S. taking steps to ease overseas access to dollar liquidity, things were looking better, with the exception of South Korea, but as the chart shows (see below), that’s no longer in place,” said Kit Juckes. global macro strategist at Société Générale, in a Tuesday morning note.

“Central banks are having to get the world’s financial plumbing to work properly, even when they think they’ve identified the problem,” he said.

Société Générale

The chart shows the cross-currency basis for dollar/euro and dollar/yen swaps. The basis, expressed in negative figures, is effectively a measure of demand for dollars and a reflection of shortages.

“The measures taken by the Fed and other G7 central banks regarding the USD swaps lines they all have with each other don’t seem to have been enough to satiate the USD demand,” Bechtel wrote. “That or the transmission mechanism for getting the USD into the right place is broken, either way the market is still starved for USDs.

“What this also tells me is that we are still in a massive deleveraging of the financial system that is sucking up all the demand for USDs,” he said.

Such across-the-board deleveraging has been blamed for extreme market volatility and widespread selling of assets over the past several weeks as the COVID-19 epidemic sparked fears of a global supply shock by disrupting trade and travel in particular.

Global equities have tumbled into a bear market. The Dow Jones Industrial Average

DJIA, +2.89%

 and S&P 500

SPX, +4.00%

 on Monday suffered their biggest one-day percentage fall since the October 1987 crash, while the Cboe Volatility Index

VIX, -9.19%

 closed at an all-time high.

The Fed’s policy actions are focused on addressing stresses in markets. On Tuesday, the Fed announced it was establishing a commercial paper funding facility to smooth functioning in that market amid signs of stress.

A weaker dollar would be a boon to U.S. companies, commodity producers and emerging markets, but analysts said there are a number of factors likely to keep the dollar supported in the near term.

While slashing the fed funds rate nearly to zero eliminates most of the yield advantage over foreign currencies which is a fundamental rationale for dollar strength, investors still don’t have a compelling reason to short the dollar, said Vassili Serebriakov, strategist at UBS, in a Monday note.

Meanwhile, renewed Fed asset purchases can weaken the dollar through increased inflation expectations and capital outflows, but with the global economy headed for possible recession due to the COVID-19 outbreak, that might not happen right away. The effect would likely be more noticeable once global economic growth expectations bottom, Serebriakov said, as was the case in 2009.

“We are not at that point yet and U.S. investors lack positive reasons to put their money overseas,” he said. “In other words, zero rates and [quantitative easing] would be most effective in weakening the dollar once global growth sentiment turns around.” Serebriakov said.

That said, if the currency swap lines and other measures can alleviate some of the stress in dollar funding markets, it would be “the first step to a weaker dollar particularly against currencies where risk premia are wide” such as the euro and Australian dollar, ” he said.

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