Why Cable is not a one-way bet at the moment
One way to look at why markets view the dollar as vulnerable is because the world is very long of dollars in reserves, even if not significantly as a share of US GDP. The short-term financing pressure on the dollar is far diminished compared to last year, as the trade deficit has shrank significantly, while Japan’s trade surplus has fallen to almost flat and the Eurozone surplus has shifted into a small deficit. Near-zero interest rates in the US make adding to dollar reserves unappealing, but not significantly on a relative basis, as interest rates in the other reserve currencies are more or less the same. The necessary regular increase in dollar holdings in reserves is much smaller than it was, so it shouldn’t present a big concern. Much of the increase in reserves happens in Asia, which seeks to defend competitiveness and adding dollars to reserves is automatic. As the US financing need is not increasing but decreasing in absolute and in relative terms, there shouldn’t be an issue for reserve accumulators at the moment.
The issue is a longer-term one as US debt is set to rise and there is perhaps some worry that the US may wipe out the debt by allowing more inflation. Each aspect shouldn’t be a real worry. The fact that US debt is set to rise does not mean that the increase will have to be bought by foreigners. Foreigners will buy debt to the extent that the US trade balance is in deficit. The debt can and probably will be bought by domestic investors, which is one reason why capital investment in the US is likely to be lower going forward as public demand for capital crowds out the private sector. As for deciding to inflate out of its debt, the US will have to be extremely short-sighted to do anything of the sort, as this will have huge negative consequences domestically, as higher inflation leads to significant instability, higher bond yields and the loss of monetary policy credibility. The US position on the global scene will also be undermined dramatically and the US will have a real dollar and a funding crisis on its hands. The US, under its current administration won’t do that.
There is the possibility that reserve holders start to diversify away from dollars in a bid to reduce exposure to more sensible ratios. The problem is that the credible alternatives are not that many. The Euro is good, but what if the Eurozone falls apart. It hasn’t been around for long enough to be sure that the Euro is safe enough. The Yen is a viable option, but Japan is a very isolated entity, with somewhat uncertain and not completely transparent policy making and there are lots of earthquakes there too. The Yen is also likely to offer no yield for a long time to come. There aren’t that many options at the moment. The dollar selling has been driven more by speculative, or maybe private sector portfolio hedging. In this context, as long as the market is worried, dollar selling can conceivably continue, but not for long, as the reserve holders, who are the ones that are really long of dollars, won’t be selling out at these levels. Not just because the dangers to the dollar are not that real in a relative sense and because there are no great alternatives, but also because dollar holders would be acting against their own interests offloading now. They will lose out from a further drop in the dollar and will also hurt the US, which will produce a backlash. Not to mention that the stability of the global economy will be severely shaken in the current fragile environment. Russia, who wants to diversify away from dollars at the moment is an isolated case, as its motivation could be political rather than economic.
Nikola Mirtchev