By George Saravelos, chief FX strategist at Deutsche Bank
We have been warning about a confidence crisis in the dollar for more than a month now. Events over the last few days are in our view validating those fears. We are witnessing a simultaneous collapse in the price of all US assets including equities, the dollar versus alternative reserve FX and the bond market. We are entering uncharted territory in the global financial system. It is very hard to foresee market dynamics in coming days but we would make the following observations:
- The market is rapidly de-dollarizing. It is remarkable that international dollar funding markets and cross-currency basis remains well behaved. In a typical crisis environment the market would be hoarding dollar liquidity to secure funding for its underlying US asset base. This dollar imbalance is what ultimately results in a triggering of the Fed swap lines. Dynamics here seem to be very different: the market has lost faith in US assets, so that instead of closing the asset-liability mismatch by hoarding dollar liquidity it is actively selling down the US assets themselves. We wrote a few weeks ago that US administration policy is encouraging a trend towards de-dollarization to safeguard international investors from a weaponization of dollar liquidity. We are now seeing this play out in real-time at a faster pace than even we would have anticipated. It remains to be seen how orderly this process can remain. A credit event in the global financial system that threatens the provision of short-term dollar liquidity is the point of greatest vulnerability which would turn dollar dynamics more positive.
- The US administration is encouraging the sell-off in US Treasuries. The first order effect of current policy is of course the generation of a large negative supply-side shock that raises inflation and makes it harder for the Fed to cut rates. There is of course the bond basis trade that is being unwound. But there is something larger at play as well: a policy objective of reducing bilateral trade imbalances is functionally equivalent to lowering demand for US assets as well. This is not a theoretical consideration: the US has this week initiated trade negotiations with Japan and South Korea, with a specific reference to currency levels being a negotiating objective. It should not be overlooked that Japan is the largest official holder of US treasuries. An implicit negotiating objective of lowering USD valuations entails the possibility of the sale of US treasuries from the Japanese Ministry of finance. We argued two weeks ago that the whole Mar-A-Lago accord framework was flawed because it imposed fundamental inconsistencies in the desired economic objectives of the administration. We are now seeing those inconsistencies exposed in broad daylight.
- Beware a trade war shift to a financial war. At the epicenter of the last few days' escalation is the trade war with China. As our colleagues have highlighted China appears to be maintaining the optionality on weaponizing the currency while signalling a far more supportive domestic economic stance. With a 100%+ tariff on China, there is little room now left for an escalation on the trade front. The next phase risks being an outright financial war involving Chinese ownership of US assets, both on the official and private sector front. It is important to note there can be no winner to such a war: it will damage both the owner (China) and the producer (US) of those assets. The loser will be the global economy.
