Emerging markets, Currencies Fitch’s US downgrade reignites global currency order debate

In our recent piece titled “ A surprise downgrade,” we recognized the US is plagued by a dysfunctional budget process, an escalating deficit, and an artificially constructed debt ceiling that is highly counterproductive.

We have also argued for some time that we expect the global reserve and trading currency order to become more diverse moving forward, with several currencies and even commodities playing critical roles.

Yet, we firmly believe we will be living in a US dollar-centric world for years to come for the following reasons:

• Global currency regimes are sticky: The US dollar dominates financial markets and international trade. Changes in the world’s dominant currency have historically taken a long time to materialize. Even as great economic powers rise and fall, their currencies’ reserve status tends to survive well past the peak of their influence. The latest IMF survey on the currency composition of global foreign exchange reserves reveals that the share of US dollars held by central banks still stands at almost 60%. The greenback is also used in over 40% of every global payment and dominates 85% of trade finance contracts, according to SWIFT.
• Liquidity is king: Liquidity ranks at the very top of the properties that global reserve managers and those involved in international trade look for in a currency. The US dollar remains the world’s dominant currency in this realm. The depth of the US Treasury bond market is second to none. The US dollar was on one side of 88% of all global currency trades in 2022, according to the BIS. It remains solidly in first place when it comes to derivatives such as forwards, swaps, and options. This is relevant, since the ability to hedge exposure to a given currency through derivatives appeals strongly to reserve managers and those involved in international trade.
• Stability and safety matter: For all the challenges the US financial and political system is experiencing, the country still ranks highly in various gauges including rule of law, regulatory quality and efficiency, and market openness (the prevalence of capital controls, for example). As a result, the US continues to attract large flows of foreign investment. Of course, the US must treat the privilege of being able to issue the world’s preeminent assets with respect. The prospect of yet another federal government shutdown in October does not help improve the country’s reputation, for instance.

Geopolitics enter the equation

Rising geopolitical tensions could trigger quicker adjustments in the global currency order. Yet, there doesn’t seem to be a sole currency that stands to benefit. The UBS Annual Reserve Manager Survey, conducted this year among almost 40 central banks from all regions, asked “Which reserve currencies or assets are most likely to benefit from macroeconomic and geopolitical shifts over the next 5 years?” Reserve managers provided a wide range of answers.

In practice, gold has become the diversifier of choice. Last year saw very strong central bank buying of gold, marking the highest level of annual demand on record dating back to 1950. Record central bank purchases have continued into the first half of this year. As the yellow metal carries no credit or counterparty risk, some central banks may deem it to be better insulated from financial sanctions. This is one of the drivers behind our USD 2,250/oz forecast for gold by end-June 2024.

Conclusion and investment implications

All in all, we think the dollar's reign will live on. At the same time, it will likely make some room for competitors along the way.

From a cyclical perspective, we expect the US dollar to weaken as the US interest rate premium relative to the rest of the world erodes in the coming months. It is important to note that our call for a weaker US dollar in the near future is not based on the assumption of a declining global currency status. With this in mind, we recommend investors diversify their fixed income and equity holdings, or position in options or structured strategies that could deliver positive returns in the event of dollar weakness.

On a relative basis, we prefer the euro and the Japanese yen. More growth-oriented investors could also focus on the British pound, while investors with a defensive mindset could still find value in the Swiss franc. Finally, we think high-yielding emerging market currencies such as the Brazilian real, Mexican peso, Indonesian rupiah, Indian rupee, and Czech koruna still offer attractive total return opportunities for investors who can handle greater volatility in their portfolios.

Main contributor - Alejo Czerwonko

Original report - Fitch’s US downgrade reignites global currency order debate, 7 August 2023.