In mid-August, the U.S. Dollar Index, which measures the greenback against a basket of six currencies, fell to its lowest level since May 2018. Against the Euro, it has lost around 10% since its peak in late March. August also saw a surge in investors shorting the U.S. dollar. 

In June, American Economist Stephen Roach said that a dollar crash is virtually inevitable. Speaking on CNBC’s “Trading Nation,” he said the U.S. economy has been afflicted by significant macro imbalances for a long time, and forecast that the U.S. dollar will fall by around 35%. He also pointed to United States’ retreat from globalization, calling such policy “a lethal combination.” 

Roach, who is the former Morgan Stanley Asia Chairman, is a respected expert, so his comments aroused a lot of concern.  However, given the U.S. dollar’s role as a safe haven in times of global volatility, could this help prevent a hard crash?

Looking back 

The greenback’s drop in value since March seems dramatic, but taking a longer view offers a different perspective. As 2020 got under way, the U.S. dollar was relatively expensive. At that time, the United States was enjoying healthy economic growth, and the Federal Reserve was among the few major Central Banks that was trying to normalize interest rates.

“Fundamentally speaking, there was a lot of attractiveness for people to put their money in U.S. dollars, for growth or for interest rates,” explained Kelvin Lau, Executive Director, Senior Economist, Greater China, Global Research, Standard Chartered Bank. 

The outbreak of Covid-19 then drove the dollar even higher, as investors moved out of riskier assets and flocked to the safe-haven currency. At the same time, other investors were trying to borrow as much as they could, due to concerns that they would not be able to borrow U.S. dollars at a later stage.

“Everyone was scrambling – either for safe-haven reasons, or just to secure U.S. dollar liquidity when things were tight,” Lau said. 

The Fed then unveiled a huge package of stimulus measures that removed concerns about liquidity in the market, while other Central Banks around the world were cutting their interest rates.

“Suddenly we were facing a global financial market of ample excess liquidity,” Lau explained. “So there is too much liquidity chasing limited assets. People started to realize that they should put their money to work; that it can’t just stay in U.S. dollars in cash.”

Investors moved away from the greenback, and pushed it down to the relatively low level that we are at now. Will this decline continue?

Standard Chartered Bank’s Lau said there is a risk that the U.S. dollar could slide more. “A good reference is the previous trough, and we are still 5% away from that.” 

Michael Spencer, Managing Director, Deutsche Bank in Hong Kong, agreed that the dollar had been relatively expensive before the Covid pandemic. Over the past decade or so, events including the global financial crash in 2008, uncertainty around the Euro in 2012, and a collapse in commodities in 2014-15, have been strong reasons to hold U.S. dollars, which helped drive up its value. So the drop of the last few months does not represent a significant fall.

“We’ve gone from the dollar being overvalued a few years ago, to now saying it’s reasonably valued,” Spencer said.

Is a further drop on the cards for the greenback? 

Covid impact

Although the global pandemic situation is generally better than six months ago, new waves of infections continue to derail countries’ efforts to restart their economies.  News about vaccines being available by next year gives hope that economies will be able to return to normal.  But this could all change quickly, with political risks, including the U.S. elections, in addition to uncertainty about the effectiveness and safety of a vaccine. As such, Lau said that investors may remain cautious.

“One key factor that will prevent market participants from going too bearish on the U.S. dollar is the fact that there are still a lot of uncertainties on the outlook, including U.S.-China trade tensions, and whether there will be a vaccine quickly enough,” Lau said. 

Another reason why there is unlikely to be a sudden drop in the value of the U.S. dollar is due to the general pattern of investor behaviour seen in response to external shocks. As Spencer explains: “When there is a negative shock, asset prices sell off quickly and the dollar strengthens quickly. Then it takes a while for the markets to recover and investors to recover their risk appetite.”

But the reaction to positive news is not so dramatic. “The market tends to be a little bit more skeptical of good news but scared of bad news.”

Global role

The dollar’s safe-haven status is partly due to the outsized role it plays in the world economy. It is the dominant reserve currency, and also by far the biggest currency when it comes to international transactions, explained Wilson Chong, the Chamber’s Senior Economist. 

“What this means is that businesses and governments around the world need to hold enough dollars to enable them to trade,” he said.

The dollar’s dominance on the global stage has shrunk somewhat in the past few decades as the Euro and RMB have risen, Chong added, but both of these have limitations. “In terms of reserve currency and as the currency of global transactions, there are no real alternatives that can match the U.S. dollar in terms of liquidity.” 

Lau agreed that the dollar will maintain its dominance in global trade. For Hong Kong, this provides stability.  

“We see value in the U.S. dollar credibility and its widespread use around the world,” Lau said. “Even though it could depreciate, as long as the underlying function and the use of it, and the credibility of the Fed is still there, these are still good reasons for the peg to the U.S. dollar.” 

Investor behaviour

As the U.S. dollar rose in March, the U.S. equities markets suffered their worst drop since the great recession in 2008. Even though the markets recovered quickly, the question remains: could they collapse again? 

Lau is among the economists who have noted a disconnect with the fundamentals in the U.S. stock markets, which suggests that a drop is a possibility. Spencer, on the other hand, said that Deutsche Bank’s equities strategists expect that the U.S. markets will end the year where they started, and does not think they are overvalued. 

In terms of impact on the U.S. dollar, any collapse in the U.S. equities markets would likely have a spillover effect on the rest of the world’s markets, which would ultimately see a return to the safe haven of the greenback. 

Hedge fund activity in August also drew attention to the U.S. dollar with data from the Commodity Futures Trading Commission revealing that investors had increasingly been betting against the greenback. 

Chong said that while the activity of hedge funds could be a signal that the currency is on a downward spiral, he cautioned against drawing conclusions from one month’s data.

And while this short selling helps explain why the dollar has been weakening over the past few months, it does not necessarily mean a significant drop is ahead. The current global uncertainty means that there are many reasons why, over the next few months, people will want to hold the safe-haven currency, Spencer explained. This could lead to a short squeeze as traders try to liquidate their positions. 

“Everyone will rush to turn their shorts into at least a neutral position, and to do that, you have to buy dollars.  We would say fundamentally the dollar could probably weaken a bit – especially if it looks like the economy will return to reasonable growth and a vaccine will be available next year,” he said.

Choppy seas ahead

Right now, the world is facing a tremendous amount of uncertainty. Besides the coronavirus, there is the U.S. presidential election, continuing U.S.-China trade tensions, and even the possibility of military clashes in the South China Seas.  Such volatility could see a strong U.S. dollar bounce. 

Hong Kong’s dollar peg means that any change in the status of the greenback will have an impact. In the short term, there seems little reason to be concerned about a slight drop. “If the dollar is broadly weakening, it is marginally positive for us. It makes things in Hong Kong a little bit cheaper,” Spencer explained.

But more volatility creates an exchange rate risk for businesses if they use other currencies, as the Chamber’s Chong explained: “For instance, a Hong Kong company that is obligated to pay a certain amount in pounds sterling will have to bear a 6% additional cost, because the Hong Kong dollar has depreciated by some 6% against GBP over the past three months.” 

To hedge this risk, the company could “lock-up” the exchange rate for that transaction in advance. But while hedging in this manner removes the uncertainty, it does not protect the company if the GBP depreciates.

On the other hand, a multinational company listed in Hong Kong will have its global profits stated in Hong Kong dollars in its financial statement, and may therefore want to protect the profits in its overseas division against a stronger dollar.

In terms of other currencies, the RMB has been strengthening recently, partly because of the Mainland’s success in containing the Covid-19 outbreak, and also because of low U.S. interest rates, which makes the U.S. dollar less attractive. The Euro has also seen a recent uptick, but as a stronger Euro will weigh on exports this could hold back economic recovery of the region. 

As Hong Kong emerges from the pandemic, the city’s economic fortunes will partly depend on events in the wider world. Stability in the global economy will be essential for Hong Kong to recover from the unprecedented shocks of 2020. The Chamber will keep a close eye on global developments and how they impact Hong Kong businesses as we hopefully move towards a Covid-free future.