Source:
https://scmp.com/comment/opinion/article/3075492/markets-panic-over-coronavirus-pandemic-us-dollar-king-time-being
Comment/ Opinion

As markets panic over coronavirus pandemic, the US dollar is king – for the time being

  • Investors’ dash for cash prompted market sell-offs last week, as US dollar liquidity is critical to the functioning of the global financial system. But looking beyond the crisis, too much liquidity could give rise to asset price inflation
The detail on a US$20 note. Whatever the Fed and others are obliged to do now is likely to have consequences that extend far beyond the duration of the coronavirus pandemic. Photo: Reuters

“Cash is trash.” That was the view of Ray Dalio, founder of Bridgewater Associates, the world’s biggest hedge fund, when he spoke to CNBC at the World Economic Forum in Davos in January. But, right now, in a global economy profoundly disrupted by the coronavirus, cash is king.

Once you accept that, recent market movements become more intelligible. Markets that are not usually expected to move together were hit by sell-offs in the middle of last week. Investors were in a dash for cash as falling prices triggered wholesale position liquidation in panicked markets.

The cash that investors needed was primarily greenbacks as ready access to US dollar liquidity is critical to the smooth functioning of the global financial system.

The US Federal Reserve, perhaps mindful of how quickly financial markets can seize up – as was the case during the global financial crisis – acted swiftly last week and again on Sunday – cutting interest rates and flooding the system with dollars.

The Fed’s shock-and-awe approach, in coordination with other central banks, was intended to calm market nerves with US dollar liquidity, the oil in the engine of the global financial system. Whether the moves prove ultimately successful remains to be seen but the monetary authorities had to act.

Yet, whatever the Fed and others are obliged to do now is likely to have consequences that extend far beyond the duration of the coronavirus pandemic. Markets will always compute, and seek to profit from, the future implications of current monetary policy decisions.

The currency markets, prior to the spread of the coronavirus, had experienced a period of low volatility. That lent itself to a build-up of carry trades, where investors seek to hold a higher-yielding currency in preference to a lower-yielding one. The higher-yielding US dollar attracted demand in preference to the likes of the euro, the Japanese yen and the Swiss franc as the Fed had tightened monetary policy while other central banks had not.

But low volatility may have also encouraged those same currency traders to take bigger positions in the hope of generating a similar profit to that from a smaller bet in a more volatile environment. As regulars at the Happy Valley racecourse know, to get the same return on a bet on a fancied horse, as opposed to a long shot, you need to play for a higher stake.

Consequently, when the foreign exchange market got the jitters, on the realisation of the extent of the economic dislocation arising from the widening spread of Covid-19, the exit from those same positions necessarily involved selling dollars and buying back lower-yielding currencies.

That reaction made sense. Currency market participants rightly grasped that the monetary authorities would respond to Covid-19 by cutting interest rates, and that the Fed, as it duly did, would not only lead the way but also have more room to cut than other central banks.

But a currency market that does not have US dollars is ill-prepared when the ready availability of greenbacks in the financial system recedes. In a situation where there is a perceived scarcity of US dollars, the currency behaves on foreign exchanges like any commodity when markets conclude that demand is outstripping supply: it jumps in price.

Consequently, the very dash for cash that prompted market sell-offs last week, prior to the Fed’s shock-and-awe response, actually helped boost the value of the US dollar on foreign exchanges as investors who needed greenbacks sought to buy them in exchange for other currencies.

It is to be hoped that the efforts by the Fed and other central banks to lower borrowing costs and enhance global liquidity of the dollar will succeed. But, until it becomes apparent that liquidity is again flowing freely through the arteries of the global financial system, the dollar might well retain a degree of poise on foreign exchanges.

Looking beyond the coronavirus pandemic, unless the Fed later drains off the greenbacks currently being injected, then those US dollars will end up staying in the global system and being invested in something or other. That, when combined with the understandable “spend, spend, spend” response of world governments to the coronavirus, could prompt renewed asset price inflation.

If currency traders were then to characterise the Fed’s post-coronavirus monetary policy settings as too easy, the greenback could dive. That’s when Dalio’s “cash is trash” scenario could play out. But not yet. Right now, cash is king and the king’s name is Greenback.

Neal Kimberley is a commentator on macroeconomics and financial markets