Dollar Dominance In the Age of COVID

This article was co-authored with Dominique Dwor-Frecaut (bio below). This article can also be found on the Macro Hive platform here. Macro Hive is a leading producer of macro and financial market research and strategy. 

The virus has catalysed more, perhaps, than it has caused. Established trends in geopolitics, economics, financial markets, public policy, and social structure have accelerated as the disorder removes the brakes from those changes – like shaking the ketchup bottle to make gravity work faster.

This is a multi-phase reaction. Some things move faster than others: information moves the fastest, then people and politics, then structures and systems. Well, we made quick progress. Within just a few weeks, the tone of the global economic and policy response was cemented, leaving only the denouement to play out. Now that the most stringent lockdowns have been lifted, they are unlikely to make a comeback, and we show why in the first section below. So, what’s left? More dollars, more debt, and more policy mutations – three global trends that got a turbo kick in 2020. In the second section below, we examine the emergence of fiscal-monetary coordination (modern monetary theory [MMT] and the ‘Fed put’). In the third and final section, we review the global dollar.

Lockdowns: Past – and Future?

The equity market has focused more on the strength and duration of lockdowns than the COVID outbreak itself. Of course, the outbreak affects the scale of the lockdown, but it’s the lockdown and restriction of people’s activities that impact the economy (Charts 1 and 2).

The recent growth in COVID-19 cases in the US begs the question, will new blanket, open ended lockdowns appear again? However, the odds are ‘no’ for three reasons: the virus has become less lethal, there is ample spare healthcare capacity, and the long-term epidemiological benefits of lockdowns are unclear while their economic costs are prohibitive.

1. COVID-19 is becoming less deadly.

There is still much debate globally about the disease’s lethality; but, in the US, symptom severity and case fatality rates (CFR) are clearly falling.   In recent weeks, CFR have stabilized in a 1 to 1.5% range.  With the CDC estimating that actual cases could be 10 times as high as confirmed cases, this could bring the Infection Fatality Rate (IFR) to a 10 to 15 bp range, that of the common cold.

Due to these milder symptoms, hospital capacity generally remains ample. And should some hospitals fill up to capacity, it would be possible to free up capacity by postponing nonessential surgeries, diverting patients to neighbouring states, or building additional hospitals as was done in March. (Those hospitals were dismantled as they ultimately went unused.)

2. The long-term impact of lockdowns on the epidemic is unclear.

COVID-19 prevalence across US states is converging. Since the epidemic started, the distribution of cases across states has converged to the distribution of population. The convergence could reflect that either containment measures make little difference on the long-term epidemic progression or that the US has no internal borders; or, more likely, it is a combination of both. Some states have established quarantine requirements for visitors from other states, but these are difficult to enforce. States generally lack the infrastructure to track out-of-state visitors. With porous borders, states’ individual containment measures are unlikely to have much long-term impact on COVID-19 prevalence.

3. The economic costs of lockdowns are prohibitive.

Elected officials are likely to weigh further damage to already collapsed economies against the falling COVID-19 mortality and limited long-term medical benefits of lockdowns and conclude that more targeted measures best serve voters. Furthermore, blue states seem to have been hit harder, economically, than red states: average unemployment is 9% in states with a Republican governor against 11% in states with a Democratic one. In addition, about 70% of workers laid off in red states since the coronavirus hit have been able to find jobs, against about 60% in blue states. These patterns lower the risk of lockdowns since red states with less economic damage have governors keener to re-open their economies, while blue states that have been hit harder by unemployment can ill afford another lockdown.

The reopening of the US economy was always going to be a trial and error process.   In this process states are learning how to best balance COVID-19 concerns with other health and economic concerns.  Following the recent measures taken by states, the increase in new cases is slowing, which suggests the surge could end soon and re-openings resume.

A New Frontier for Fiscal and Monetary Policy

The global fiscal and monetary policy response is remarkable not only for its breadth and magnitude (in some places ‘infinite’), but even more so for its redefinition of the contours of policy itself. This is true for both fiscal and monetary policy, but also in their relation to each other.

Just in time, modern monetary theory’s tour of the media and academia in recent years grants us a framework to interpret recent policy turns. What would it mean if these two arms of government policy were coordinated, rather than independent? What would it mean if central banks began to systematically[1] incorporate fiscal objectives – by guaranteeing to fund them? Or if fiscal policy inched closer to the central bank’s turf via policy meant to target employment and inflation? This is the new policy paradigm (Chart 3).

Synchronized issuance and purchase of government debt by the fiscal and monetary authorities respectively is (the monetary side of) textbook MMT.[2] The fiscal side is poised to emerge in our ‘economic recovery plans’.[3]

In addition to purchasing government debt, the Fed is also offering (some)[4] foreigners the chance to sidestep Treasury sales to obtain dollar liquidity, through swap and repo facilities (Chart 4). But in these measures, they agree to a paradox. Although they’ve prevented a larger sell-off of USTs, they’ve also reduced one component of the structural demand for them: as a buffer for moments just like this when liquidity is challenged. If the Federal Reserve will offer a lifeline when things get bad, then Treasury debt is a less important asset.

The Fed explained its intention to prevent disruptions to the Treasury market and upward pressure on yields. The question is why. Are central banks controlling long-term borrowing rates for their governments? If these purchases of public debt are in pursuit of monetary objectives, why are they focused at the long end of the curve (7-30 years) in what is largely a real-economy liquidity crisis?

The Global Dollar

The market turmoil of Q1 exposed many things. In foreign exchange, it exposed mountains of dollar liabilities around the world and, beyond that, heaps of dollar liquidity preferences.

This grey line represents the premium that agents pay for short-term USD cash, over and above any local rate differentials (Chart 5). That premium is generated by a demand for dollars unmet by the combined US banking system and the offshore dollar market. Corporations and governments everywhere grappled for USD to cover their bills, and, until the Fed stepped in, there wasn’t enough. In March 2020, there was only one currency in the green.

The ‘dollar system’ that caused this reaction has three main pillars.

First, the USD is the most universal unit of account: for commodity markets, international trade, and much more.

The second is the abundance of dollar assets in the world, USDs and USTs being front and centre. These claims on the US government serve as a capital bedrock for much of global finance.

Third is the dollar-denominated liabilities of nations, corporations, and households around the world. Since 2008, the share of USD-denominated debt across the private and public sectors worldwide, as well as in trade invoices,[5] has grown significantly (Chart 6). These liabilities generate a demand for dollar liquidity. When the pandemic hit, dollar demand was up. Just as governments closed borders, they also clamoured for the currency they shared with their neighbours.

Although many stakeholders (including the US?) would like to disengage from the system of dollar dominance in the long run, the crisis may have solidified it in the near term. The dollar has been a major funding currency for COVID-19 expenses worldwide, and this will create an even deeper demand for dollar liquidity in the future. If anything, the scale (and share) of new dollar credit further entrenches dollar demand in the future. $92bn in approved financing from multilateral development banks and the IMF,[6] over $100bn in emerging market sovereign USD debt, up to $450bn in Fed swaps, even more in corporate and household credit. It’s not all in dollars, of course – but most of it is.

And yet, it may be hard to specify COVID-19’s marginal effect on borrowing because we were already in the middle of a credit boom, especially in dollars. Indeed, just before the crisis kicked off, emerging market governments and companies set a January record for foreign currency borrowing, at $118bn. So if, in general, financial crises are marked by system-wide deleveraging, followed by policy and other efforts to get credit flows back up – well, then this is kind of like that, but without the first step.

Dollar debt issuance by sovereigns, supranationals, and government agencies in Asia (excl. Japan) reached its fastest rate in 10 years in April ($18.7bn), and total issuance in 2020 is twice the amount of the same period in 2019. Part of that is an anticipation of higher expenditures and lower tax receipts, but did it also play a role in the reversal we’ve seen in exchange rates?

Some EM countries might be avoiding dollar borrowing (instead turning to domestic capital markets or their own central banks in the case of Turkey or Poland) but for an identical reason: not to alert international markets to the scale of deficits, to avoid devaluation of their currencies. For many of these countries, dollar liabilities were already very high, and a weaker currency increases solvency risk.

Liquidity and solvency crises will linger in household, corporate, and national balance sheets for weeks and months to come as the clamp on economic activity endures – and even afterwards, when we see that the transformations we underwent in a hurry won’t be erased in the same rush.

The Fed made big strides further into the centre of domestic and global markets. That’s not a position it can easily leave. It has succeeded in capping Treasury yields, corporate credit spreads, and the dollar’s exchange rate, and in stabilizing equity markets (Chart 7). Whether it succeeded in getting money to where it might have averted a liquidity crisis in household, corporate, or national balance sheets remains to be seen. There is reason to believe that the swift monetary expansion has actually limited credit flows: the money’s circuit back into banks’ deposit liabilities raises the reserve capital required by regulatory ratios of adequacy and leverage (Chart 8).

From here, we see more dollar everything. More dollar assets, more dollar liabilities, more dollar cash. Too much?

We outlined above why we see the events of 2020 further entrench the dollar system. At the very same time, we also recognize the paradox that the financial and political ‘leverage’ required by the Federal Reserve and US government to smooth the outcome for the global financial system is a threat to the selfsame system, in particular through the debasement of its common currency.

‘Overextended’ is a relevant concept, a term borrowed from the discourse around US military power after 9/11 and its pursuit of wars in the Middle East. The analogy is relevant, though, because then, and now, the US was indeed overextended, but there was no recognizable adversary to take advantage of the fact – except in guerrilla fashion. Similarly, global money could look like a guerrilla struggle. Perhaps there won’t be a consolidated replacement like the euro or renminbi because perhaps there won’t be a consolidated system. We already see guerrilla money in the gold revival, the promise of Bitcoin, the RMB commodity markets and regional trade, cooperation in the non-dollar bloc (e.g., swap lines between Qatar and Turkey), not to mention Europe’s desperate attempt to step up.

In 2020, the dollar system got a lot bigger, but the non-dollar system grew too. If US inflation expectations ever become unanchored, or the weaponization of the USD through sanctions crosses into the intolerable, we will see more guerrilla successes. Yet, for now, dollar is king.

 

 

[1] Beyond intentionally pursuing fiscal policy, maybe the Fed is doing so incidentally as well? Mohamed El-Erian asserts so.

[2] Yes, there is a textbook—by Professors Mitchell, Wray, and Watts.

[3] https://www.cbpp.org/research/economy/fiscal-stimulus-needed-to-fight-recessions. Abba Lerner’s theory of ‘functional finance’, relied on during post-WWII reconstruction, may be poised for a comeback.

[4] https://www.ft.com/content/6882defd-bb7a-4732-a5de-a7a69886002d

[5] Gita Gopinath (2015), “The International Price System”, National Bureau of Economic Research Working Paper 21646. https://www.nber.org/papers/w21646

[6] IMF financing is accounted in Special Drawing Rights, ~42% of whose value is US dollar, the rest split between euro, renminbi, yen, and pound sterling.

 

Dominique Dwor-Frecaut, Macro Hive

Dominique Dwor-Frecaut is a macro strategist based in Los Angeles.  She has been producing alpha generating trade ideas in FX and rates in EM and G10 at established and startup macro hedge funds in the US since 2011, including at Bridgewater.  She has also produced in depth analysis of central banks policies and procedures drawing on her experience at the New York Fed, the IMF and the World Bank as well as on the buy and sell side.  Before moving to the US she covered Asian and global EMs at Barclays capital, ABN AMRO and RBS from Singapore.  She holds a PhD in economics from the London School of Economics.

 

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