Everyone knows the facts; FX is the biggest market in the world. Everybody needs it, everyone uses it. Its liquidity is unparalleled, and its depth has no match, but that does not mean it is easy to decipher. For decades brave men and women have tried to figure its intricacies and make sense of its many complex factors. Sometimes to great success and other times with spectacular failures. There are a few things that have remained constant, a biggie is the safe heaven factors. In times of peril the USD strengthens. That is a rule by which we live. It is the reserve currency of the world, and we know its demand increases with any spike in risk. It is a safety-blanket of sorts. When there are hardships in markets, having US Dollars allow you to sleep better, but is that about to change? Has the recent turn of events and the unprecedented response from the FED distorted this fact and dented the safe heaven status of the USD? It is a question that has tremendous implications for the future of capital markets. It would be the biggest paradigm shift in market history, and, I would guess there is no way any market participant would be ready for it. Let’s dig a little deeper, for that, we can turn to the charts.
Let’s look aa a daily chart of the EURUSD vs. the SPX. It shows a remarkably strong correlation. As the SPX continues to grind higher, the EUR strengthens.
Recently we have seen some pretty decisive moves by other countries trying to end the decade’s long hegemony of the USD. We saw the Russian Wealth Fund, a $ 185 Billion entity, ditch the Dollar for other currencies. We have also seen several of the world’s biggest nations chip away at the Dollar’s dominance. The emergence of China as a dominant player and the strategic location of the EU have had an impact on how reserve managers allocate. It is not surprising that the Dollar’s leadership is being put to the test.
But what are the alternatives? What can reserve managers hold instead of USD? Is there anything on the horizon that could replace the liquidity it offers? Is that even the right way to think about it? Can a basket of currencies be cobbled up that offer the same safety that the USD does?
Here is a startling fact, 79.5% of global trade is done in US Dollars. Another impressive statistic, the EURODOLLAR market, that totaled about $ 14 Trillion in 2016, is estimated to be north of $ 50 Trillion now. Needless to say, the market is short dollars.
What role does the BOND market play in all of this? As BONDS continue their torrid decades-long-rally, there is the pending issue that market forces could take yields into negative territory. That not only would be unprecedented, but would alter the capital market landscape in a major way.
The chart of the 10-year bond tells a graphic story. This would not be the CENTRAL BANK pushing for negative rates. This would be market forces taking rates negative, a major difference.
Are we headed towards an environment where bonds will yield negative returns? Talk about a major distortion in markets. What implications does that nugget have on the USD?
I don’t have all the answers. I truly wish I did. I have always been one who seeks the safety of the USD above all else. I have seen my fair share of sigma events and what ensues after, a massive USD spike. I am slated bullish USD as I feel uneasy with the way risk is being priced, but I am uncertain. I do not know what the future holds for the USD. One thing I am pretty convinced of, if there would be a paradigm shift away from the USD, it will catch the markets by complete surprise.
Oscar G. Salem
Founder, Managing Partner
BCM Partners, LLC