Central banks have tried to ensure that sufficient US dollar liquidity is available in times of stress through central bank liquidity swaps

While it is undoubtedly easier to focus on the more observable influences when trying to predict currencies, such as central bank policy, economic growth, politics and more, there are a multitude of other factors that are important as well that don’t get similar airtime. One such factor is the borrowing and lending of currencies overseas and such factors not only have a big role to play in determining the value of the US dollar but could be a cause of weakness in the future.

There have been a number of studies recently trying to link US dollar funding flows with movements in the value of the US dollar. One of the more recent pieces of research, from the BIS argues, like many others, that as non-US banks increase their dollar lending it tends to lift the value of the US dollar. Why should this be the case? It is argued that non-US banks that lend US dollars usually have to secure those US dollars first, and often through the FX swap market. In doing so this extra demand puts pressure on the funding market, as reflected in FX basis swaps, for instance, and leads to a rise in the US dollar. In other words, the more the US dollar is lent internationally, the weaker the US dollar becomes. So, which is correct?

In some senses both views might be correct. For instance, in times of acute financial stress when the demand for US dollar liquidity increases we do usually see a stronger US dollar; often a dramatically stronger US dollar. Such crisis situations have been seen with the pandemic or, before that, the 2008 global financial crisis. These episodes saw the US dollar rise sharply, at least initially. Of course, central banks have tried to ensure that sufficient US dollar liquidity is available in times of stress through central bank liquidity swaps, and these measures are largely working.

Nonetheless, periods of extreme stress can see US dollar strength as banks scramble to source the US dollars necessary to fund their US dollar loan book. However, crisis situations are – fortunately - the exception rather than the rule and, in our view, what happens the rest of the time is that stronger dollar lending is more likely to be associated with a weaker dollar.

This is said because the US dollar is the main financing currency globally with over 50% of international loans denominated in US dollars and over 60% of international debt securities. This means that the demand for US dollar funding tends to rise when economic and financial conditions are good.

For instance, investors might want to put more money to work in risk assets like equities or corporate credit and will often fund such positions by borrowing dollars. If these assets rise in value then investors have asset positions that exceed the borrowing required to fund them and they can scale down the borrowing if they choose. One way to do this is to sell the ‘excess’ dollars in the spot market – which bears down on the value of the dollar.

In other words, looking at things this way supports the more traditional idea that periods of global economic and financial market improvement are more likely to see the US dollar fall than rise. Now clearly this does not apply all the time; nothing does in the world of foreign exchange. But, for the most part we think it does.

Moreover, if such improvement in the economic and financial market environment stems from the Federal Reserve lowering these funding costs, through cuts in the Fed funds target, we get to the ‘traditional’ view that Fed cuts lower the US dollar. If this seems the likely course of events this year for US rates then the US dollar seems likely to give ground – even if such rate cuts spur greater international dollar borrowing.