The change in reserve accumulation

 

We get used to an environment that may have existed for a decade and assume the recent past is the norm, yet we often find cases where recent history is the exception. Look ta the resereve accumulation around the world and we are seeing that high reserves as a means of protecting currencies after the Asian currency crisis in 1997-98 may be a thing of the past. This has implications for the dollar and for US Treasuries. There is less need for safe reserves, so this key source of demand is gone.

We are seeing significant purchases of dollar securities from foreigners, but the flows are in private equities and bonds as well as government bonds. These buyers are likely more price-sensitive and profit maximizers. This means their response to news should be stronger. Unfortunately, it is not clear who the end buyers are. This demand could come from hedge funds with offshore assets owned by US citizens. Nonetheless, dollar flows will be more news-sensitive and less stable.

Are global reserves moving away from the dollar?

The share of dollars has been declining, but not consistently across countries. Some have increased their dollar share while others have reduced their dollar exposure. In a NY Fed blog posting, “Are Central Banks Moving Out of Dollar Assets?” the authors try to disentangle the problem through two channels. One is the preference channel, which represents a change in the desire to hold a specific currency. For example, it can be a desire to hold fewer dollars. The second channel is the reserve change channel, which represents a change in the overall amount of reserves held. If a central bank has less dollar exposure but increases its overall reserves, overall dollars held will decline when central bank data is aggregated. 

What is clear is that the change in preferences has centered on a limited number of large central banks and does not represent a shift in behavior across all reserve holders. Second, some of the decline in the dollar share of foreign reserves is caused by large reserve holders that have had a lower allocation of dollars but have seen an increase in overall reserves. 

In conclusion, dollars as a percent of all reserves have declined over the recent reporting period, but the reasons for the decline suggest it is not a wholesale rebalancing of dollar exposure.  

 

The dollar cycle is heading down?

I don’t believe there is an inherent reason for a dollar cycle. The evidence, at least from the chart, suggests a pattern in the dollar’s behavior. No, there may be movement away from extremes, a form of mean reversion, such that if the value of the dollar gets high, policy, trade, and capital flows will reverse and cause a change in trend. We should see this more clearly through a valuation model or with the dollar’s real value. Of course, extremes in the dollar will also be affected by the behavior of other countries, since an exchange rate is a relative price. But for now, let’s take the chart at face value, which suggests the dollar has been on a ten-year strengthening run that is reversing. This change started in 2024 and looks to continue. From a policy perspective, high inflation in the US relative to many other countries suggests a decline that will continue until the Fed can get back to its 2% target and show it is committed to taming inflation. Second, the declining dollar is linked to falling Treasury safety, which will require better control of the US federal deficit. 

The dollar has no inherent cycle. However, policy behavior may follow a cycle.

Yen intervention can buy time not a solution

Always bet against intervention if there is no change in policy. Now, this does not mean you should fight a central bank in the short-term. It does mean that intervention has to continue if it is to work. Central banks are much savvier with their intervention. It will occur when there is limited liquidity. It may come through markets not expected, like EUR/JPY instead of USD/JPY. It will be followed by rhetoric to reinforce resolve. It will occur through selected banks to ensure not all are harmed. 

It can buy time but it cannot buy a solution.

Yen intervention will not change fundamentals

 

The coordinated Yen intervention continues as we see the currency has continued to improve. Short-term intervention can reduce volatility, but this is not a volatility problem. This is a policy problem, and nothing has changed in policy. The Bank of Japan has moved its target rate to 1% and has provided forward guidance that it expects rates will continue to move higher. If this is the policy, then the yen carry trade will be reversed, and there will be further upward pressure on US Treasury rates.

The expectation is that short-term intervention will stop the yen slide and reduce pressure on global rates, but that is not how markets work in the longer run. There is no change in BOJ policy, no change in Fed policy, and no change in global imbalances. Hence, the markets will readjust their positions and currency rates will have to adjust. The process can be slowed but not reversed. 

Gold taking up the slack of lower dollar central bank demand

At some point, the fiat money producers will believe that fiat money is losing its value. There will not be an announcement, but there will be a slow adjustment. Look at the reserve assets held. Central banks are expected to reduce their exposure in dollars. They have already seen an increase in gold holdings. Now you have to be careful when looking at gold, because a large percentage of the increase in reserve exposure is not from more tonnes of exposure but through an increase in price. 

That said, most central banks as of mid-June expect that gold will move moderately higher even after the poor second quarter. Will we see the highs from January and February this year? Unlikely, but there is more upside than downside for gold in the second half of the year. 

 

Large moves in the FX markets

 

In the paper “Large Moves in the Foreign Exchange Market", the researchers show that large currency moves are not random but related to the term structure of option-implied volatility. The difference between short-term and long-term implied volatility is a good predictor of the absolute value of current moves. Given this information, investors should buy straddles when the volatility curve is inverted. Being long the straddle allows for gains in either direction.

The implied volatility inversion provides useful information that can be exploited through straddles. It makes sense that high short-term volatility will likely see greater-than-average moves. 

The Doom Loop - Explaining the dollar

 

The Doom Loop: Why the World Economic Order Is Spiraling Into Disorder by Eswar Prasad is a good book for explaining the current trouble with the dollar for anyone who wants a non-technical read on the subject. It focuses on the intersection of economics, finance, and geopolitics rather than on the theory of international finance. 

The book’s main focus is that we are caught in a destructive feedback loop driven by a changing geopolitical environment. The movement away from US hegemony in globalization is now being replaced by a fragmented system with more dispersed economic and financial power. We should not go back to the old system, but globalization created fissures that cannot be undone. The backlash to a global hegemony of rules and governing institutions means that a single currency cannot dominate the world and create a stable world order. 

Can the dollar be replaced? The answer is no: the dollar cannot dominate, which means there will be more financial instability in a world order it cannot control. 

Decoupling dollar and Treasury privilege

 

When we think about the exorbitant privilege of the US markets, the question should be divided into two parts. The Treasury privilege is associated with financing at lower rates than in other countries and with the dollar’s use across the information finance landscape. They are not exactly the same thing. 

The paper "Decoupling Dollar and Treasury Privilege" shows a difference in the convenience yields between Treasuries and the dollar. The convenience of the dollar is measured by the covered interest rate parity (CIP) between risk-free bank rates, SOFR, and the convenience yield of treasuries, which is captured by CIP deviations in government bond yields. There has been a divergence between these two convenience yield measures. 

The dollar convenience yield exists in the post-GFC period, while the convenience yield for Treasuries has turned negative, especially for longer maturities. The authors argue that this change in Treasury yields is related to the excess supply of Treasuries. This sends a clear warning that the US Treasury cannot finance debt at the current rate. 

King dollar - can it be toppled

 

I was expecting a standard book on the history of the dollar’s rise, and the reasons it should be a dominant currency, as well as why it will fall. I have read many articles on this topic and thought I would get more of the same with King Dollar: The past and future of the world’s dominant currency. I was surprised by something different. While I don’t always like the breezy approach of new reporters to complex economic topics, I found this an interesting read. 

Blustein takes the reader on a different ride, focusing on the plumbing of banking through SWIFT messages and CHIPS. It provides a unique look at the history of clearing and the ascent of the dollar that many monetary theorists avoid. More importantly, the author focuses on how the anti-money laundering efforts of the US Treasury have an important impact on banking and the use of the dollar. There is a vast amount of behind-the-scenes efforts to control the flow of dollars for the benefit of the world economy, yet this interference has a dark side that leads some state actors to avoid surveillance. The attempt to restrict Russia from global banking and trade shows how regulation and oversight can affect the flow of money. The author also reviews the work to develop CBDCs, central bank digital currencies.

As alluded to in the final chapter, for the "king currency" having a throne comes with great responsibility.

 

I am not worried about de-dollarization, I should be worried about the de-dollarization

 

There has been a lot of talk about de-dollarization amid the dollar's decline this year. The talk may be overblown. Dollar trading remains dominant, and the share of dollar-denominated assets held by central banks has only slightly decreased over the last few years. There is no dollar crisis, yet there are some concerns that investors should follow.

The dollar was not the dominant currency even when the US became a manufacturing powerhouse at the beginning of the 20th century. It took time to dominate and a world war. 

The Chinese cannot become a reserve currency, yet it is clear that it is the key currency for trade finance. Large trade surpluses mean the Chinese are dominating global trade and, with that, require financing for purchases, and importers are having to turn to Chinese funding to get it done. There is demand for the currency because importers may have to pay for goods in renminbi but finance the time between invoicing and the sale of the goods. Importers will be locked in a renminbi system.

The dollar slide - more than an adjustment?

 

The dollar is overvalued. It has been overvalued for years, and the size of the overvaluation going into 2025 was extreme, similar to the mid-1980s when the Plaza Accord was implemented. There is a clear reassessment of the dollar, despite many foreign investors still being interested in holding US assets. Investors are now willing to hedge their dollar exposure. A policy of lower interest rates, coupled with expectations of inflation above the 2% target, and slower growth expected in 2026, all contribute to a lower dollar mentality.

That said, there is no dollar substitute, as measured by the use of the dollar in trading and cross-border finance. The adjustment in dollar usage will be slower than any market change in the dollar, so it may be too early to make judgments on dollar usage; yet, current measures of dollar internationalization have remained within normal bounds. A switch to the EUR is unlikely given their economic malaise. The natural switch will be to China, yet the CNY is not a liquid or easily convertible currency. There is more pricing in CNY and factor financing in CNY, but it is not being accepted as a store of value. 

While the dollar move is much larger and faster than we have expected, the current move is a natural adjustment that takes us back to a long-term average. Dollar selling should continue. There is no reason to expect a reversal. This adjustment should not be concerning, even though the geopolitical language of today is abnormal.   

The dollar is still the dominant trading currency

The tri-annual currency survey is out, and some may be surprised by the results. The US dollar remains the dominant trading currency. It is involved with 89.2 percent of turnover, up slightly from 88.4%. Nevertheless, there is an increase in CNY trading to 8.5 percent from 7 percent. This increase is coming at the expense of GBP and EUR trading.

Overall trading volume is higher, despite the talk of deglobalization and reduced global trade, and the trading is more dispersed, with reporting banks representing less than 50 percent of the total trading.

 

Ken Rogoff's new book - A great way to understand international finance

 

This is a book that is a historical retrospective of the many key issues that Ken Rogoff researched over the last four decades. It is autobiographical as Rogoff walks through how he was engaged with many of the key topics of international finance. It was quite a run of problems: 

• The Cold War
• The Asian currency crisis
• The rise of China 
• The issue of Japan and currency moves
• The single currency in Europe 

All of these policy and economic issues required fundamental research to make the right choice and understand the crises being faced. Rogoff makes all of the issues approachable. The complexities are presented clearly, mixed with personal stories. If you want to understand the problems of international finance over the last few decades, you could not do better than read this book. 

The loss of dollar dominance

I have written that the dollar decline is significant, but the fall only places the current dollar value near the long-term average. However, we need to acknowledge the extreme moves in the dollar over the last six months. The reason for the dollar decline is truly self-inflicted on the part of the US.

The dollar decline is not driven by systematic factors that would have been picked up by a quant model. The trend/momentum would have called for a short signal, but the exogenous factors have not been seen in past data. Growth in the US is not below the rest of the world. There is the threat of a recession, but the numbers do not suggest lower relative growth. Inflation is still higher than desired, but again the numbers do ot suggest a dollar decline. 

The three areas of concern are uncertainty, trade, and debt. Usually, higher uncertainty will lead to a flight toward safety, but in this case, the uncertainty is with the US. The trade and tariff issue is real, but we lack sufficient evidence of past tariff changes to accurately determine the correct dollar response. In the case of debt, there is clear evidence that large deficits will impact currency demand. Here is where the problem is centered, and there is no clear solution. The current deficits will not be solved with the budgets being suggested. There is a potential credit crisis with the dollar. 

Dollar - Down but not out - Look at longer-run

 

The dollar has reversed two years of gains against advanced economies, but the moves are more muted compared to the broad dollar index and emerging markets. The speed of the decline is a concern, yet the dollar is still within a long-term range after a substantial gain. The question is whether the dollar is declining because there is less confidence in the US economy and financial system. It is a signal of US weakness, and that is a problem. 

The dollar remains the reserve currency, primarily due to its role as a medium of exchange; however, the store of value argument is problematic.

Machine learinng and currency trading - still driven by momentum and carry

Traders are still dealing with the puzzle of currency prediction. For decades there has been a simple challenge and research conclusion. Most models cannot beat the random walk at predicting currency movements. The machine learning explosion allows traders to explore different methods for looking at the same data. In a new paper, "Machine Learning in Foreign Exchange", the author looks a number of prediction techniques including neural networks and tree-based models. It finds that a neural network approach outperforms linear and tree-based models and can do a good job of predicting cross-sectional excess returns. It can beat the random walk but the predictive power declines at longer-term horizons. 

A non-linear approach does much better than simple linear models; however, many avoid using ML techniques given their more difficult explainability. The author uses local interpretability techniques like DeepLIFT and Layer-wise Relevance Propagation (LRP) as well as Shapley values for global interpretability. What should not be surprising is that the key factors we always know as important for explaining currency returns still hold. Momentum and carry are still the most important factors for making currency predictions, yet  it is how and when they interact with currencies that matter. The non-linear influences dominate currency production. Use the same features but link them together in new ways.

Now, when looking at the set of models. It is not always clear why one approach does better than another. There clearly may be overfitting with some models. The feature importance also are complex. There are many carry features that can provide forecast value which seems odd. Nevertheless, there is a lot of good work her which needs further testing to further support currency predictions.

The future of the dollar today - there is a framework for this discussion

 

The discussion on the dollar's decline is at a fever pitch. While the dollar's demise has been an ongoing topic, it has never been as front and center with investors this century. The talk has been one-sided, with all commentators focused on the dollar's decline. It is a question focused on when, as opposed to if. Yet, little work has framed the question appropriately through criteria for why the dollar will lose its premier status. 

Nevertheless, a good book on the subject has provided a valuable framework for thinking about the dollar's value. See The Future of the Dollar. The editors, Helleimer and Kirshner, engaged with some of the leaders in international political economics to generate different views on the dollar's future. The framework of looking through market-based, instrumental, and geopolitical lenses is a helpful way of focusing on the key issues concerning dollar dominance. The dollar dominance can either be sustained, albeit with stress, or in decline. The three-level approach provides the stories for each of these choices. The book also presents the best way to classify different parts of the world based on their relationship with the dollar. Although this book is over a dozen years old, the characterization still fits the current time. The exception is the rise of China and how the current tariff wars fit within this framework. 

Will the dollar lose its dominance? The decline in dollar hegemony is not likely to be reversed, yet it will remain dominant. The dollar is overvalued. There will be a standard adjustment. The move to US neo-isolationism with trade will cause the dollar to lose importance, and the use of sanctions to isolate other countries will place more downward pressure on the dollar. This seems to be conventional thinking, but unlikely to be wrong. 

Dollar and bonds going in different directions

 

There are usually strong relations between the US bond market and the dollar. The dollar goes up when yields go up. The higher yields attract more foreign investors and are usually a commentary on tighter monetary policy. However, we now have bond yields and the dollar moving in opposite directions. This was an immediate response, but it is telling that there is a desire to no longer hold US bonds and/or the US dollar. Think of this as an abandonment of the safe haven, which is no longer safe, and a movement to a home bias by foreign investors. 

Currency factors as cluster approach

 

There has been extensive work on currency factors such as carry, value, momentum, and volatility, yet currencies may be unique from equities. The movement of returns in currency may be based on factors that are based on how they may cluster. In "Currency Factors", the authors focus on clustering of currencies into baskets and not traditional factors. They find that G10 currency co-movements can be explained by a limited number of clusters, a dollar currency and a European currency cluster. These clusters can be further extended to a commodity factor cluster and a world factor cluster based on trading volume. This suggests that a mental model of viewing currencies within their cluster and then within traditional factors may be a method to form quick judgments on the co-movement across currencies.