Dollar weakness to persist

Thanos Papasavvas, Head of Currency Management at Investec Asset Management, maintains his negative outlook on the US dollar and expects continuing weakness in the medium term across both major developed market and BRIC currencies

We believe that the case for a period of dollar weakness rests on three ‘home-grown’ and one external factor:

‘Home-grown’ factors:

1. The pickup in global recovery is quickly reversing the “safe-haven” demand that supported the sharp rally in the dollar back in the fourth quarter of last year.

2. Secondly, deeper structural negatives for the dollar surrounding the twin deficits on the current account and government budgets are likely to come back into focus as tax cuts and spending increases temporarily boost US domestic demand over the coming quarters.

3. Thirdly and perhaps most worryingly, the wholesale adoption of “quantitative easing” by the US authorities has introduced a new medium-term threat to holders of US Treasuries on the back of potential debt monetization and, eventually, accelerating inflation.

The external factor:

The diversification out of US dollars amongst central banks and reserve managers should maintain a negative bias for the medium term. The percentage holdings of US dollars amongst central bank forex reserves have been steadily declining, and we expect this trend to continue.

We first highlighted growing Chinese concerns over the dominance of the US dollar in global foreign exchange reserves around the time of the G20 meeting last April. Since then, other members of this nascent geo-political grouping have joined in with the general call for a reduction in the dominance of the US dollar in world trade and payments. More recently, Brazil and China agreed a pact to settle bilateral trade in each other’s currencies rather than the dollar. This extends a number of initiatives from the Chinese over recent months to “dis-intermediate” the US dollar from its trading relationships with EM Asia and commodity producers, by extending RMB “swap” lines to partner central banks.

To conclude, in our view, it is only a matter of time before this growing economic importance is recognised by inclusion in the formal IMF SDR (Special Drawing Rights) basket – a first step on the long road to becoming fully fledged members of the reserve currency universe.