The US dollar has dominated in the FX market.

Quite understandably, there has been a lot of discussion about the US dollar in recent months; most of it seems to be bearish. In addition, much of the discussion about future US dollar weakness relates to the risk that the dollar loses ‘status’.

Many analysts expect the US dollar to decline, but they do not see the US dollar losing status materially. In short, the US dollar does not have to lose status to lose value; it can depreciate without any change in its status. To see this, we first need to be clear about what we mean by the US dollar’s status or, the US dollar’s global dominance.

As we all know, the US dollar is dominant in many facets of the international financial landscape. Most FX reserves of central banks are held in US dollars, most trade is invoiced in US dollars, and most international bond issuance is in US dollar as are other forms of international lending. And, when it comes to turnover in the FX market, the US dollar is on one side of around 97-98% of FX transactions. So, the US dollar has ‘status’, and it is clearly a status that is unmatched by others. But does it follow that this status lifts the value of the US dollar, and that losing this status undermines the US dollar?

For a start, history shows that while the status of the US dollar seems to have risen inexorably for many decades, its value has not increased in tandem. Instead, it has been through some substantial long-term swings, often lasting a decade, or more and, during which, the US dollar has risen or fallen by 40% or so in trade-weighted terms.

In short, the US dollar’s growing status does not seem to have prevented US dollar weakness in the past and there seems no reason to suppose that a decline in the US dollar’s status, or global role, is required to make the US dollar fall in the future. To see this just think about some examples. For a start, the US sucks global investment into its bonds, stocks, and FDI, which is why it has an external deficit of over USD26tr.

This is part of the reason why the US dollar dominates in the FX market. If these investors grow bearish on the US dollar, they can increase their FX hedges. Doing so does not undermine the US dollar’s dominance in the FX market. Instead, all that happens is that what might have been spot US dollar purchases in the past become FX swap deals as investors cover the risk of the US dollar falling. The overall level of FX activity, and US dollar dominance is the same but the US dollar’s value is more likely to fall if FX hedge ratios are lifted.

When it comes to international borrowing in US dollars which accounts for around 60% of global issuance (compared to around 20% for the next biggest – the euro), those borrowing the greenbacks might be more inclined to hedge or sell out the dollars received if they become more bearish. It might still be the case that the dollar is the go-too currency for international borrowers, because of its depth and liquidity, but it does not mean that borrowers have to hold onto the US dollars. The same is true when it comes to currency invoicing.

It might still be most convenient for exporters to the US (or many other countries) to receive US dollars, and so keep the dollar’s share of trade invoicing high, but they don’t have to hang onto these dollars. FX reserve managers might still like the liquidity of the treasury market to hold their bond assets, but they can hedge out the FX risk into another currency if they take a dislike to the US dollar.

Many analysts and investors in the FX market will also argue that their bearish views about the US dollar from here are not reliant on a decline in the greenback’s status. But Steven Barrow, Head of Standard Bank G10 Strategy, concerns that so much of the discussion around the US dollar right now is intertwined with this narrative about the US dollar losing status that many might feel that the US dollar has to lose status in order to undergo a meaningful decline. This is wrong. In fact, and perhaps counterintuitively, a decline in the US dollar might be the best way to preserve its dominant status because a never-ending rise in the greenback could make the dollar too expensive to use.