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USD appreciation: I need a dollar

15 Apr 2020

Appreciation pressures on the dollar and a sudden drop in funding could make the US currency an Achilles’ heel for institutional investors in the current crisis.

“Bad times are comin’ and I reap what I don’t sow, well let me tell you somethin’ all that glitters ain’t gold,” warned US singer Aloe Blacc 10 years ago. As liquidity in safe haven assets, including the US dollar, dries up, institutional investors might want to take heed.

As fears over the impact of Coronavirus have spread across the markets, the dollar has surged against other developed market currencies. By the end of March, the Broad Dollar Index, which measures the value of the dollar relative to other currencies, rose above 126 basis points (see graph), the highest level for 14 years, according to the Federal Reserve.

Rates in currency units per U.S. dollar except as noted
Release Date: Wednesday, April 01, 2020 Source: Board of Governors of the Federal Reserve System

While the appetite for dollars is reminiscent of the 2008 crisis, the underlying drivers are now different. Back then, demand was driven by over-leveraged banks. Now institutional investors are part of the problem.

In the aftermath of the 2008 crisis, banks withdrew from market making due to more stringent constraints on leverage. As a result, other financial actors, such as asset managers and asset owners, are playing a much bigger role in the short-term dollar market.

For example, as UK pension funds are increasingly invested in global rather than UK-domiciled assets, most of their equity portfolio tends to be held in US dollar-denominated assets, putting demand for currency hedging high through FX swaps on the agenda.

The annual turnover on dollar-denominated derivatives has surged to $3.27trn (£2.66trn) from $653bn (£4.58trn) in 10 years, according to the Bank of International Settlements.

By March 24, long positions on the dollar by institutional investors and asset managers surged by almost 3,000 to 10,879 and leveraged funds held more than 11,000 long positions, while intermediary dealers held less than 1,000, according to the Commodities Future Trading Commission.

The medium-term implications of this trend are, among others, that the interest rate of the dollar in cash money markets and in FX swap markets has widened, offering risk-free arbitrage opportunities whilst making it more expensive for international investors to hedge currency risks. But the rising valueof the dollar is also bad news for borrowers of US-denominated debt, an issue which could turn into a headache for those exposed to emerging market debt.

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