Has US dollar's correlation with uncertainty broken down?

What is different this time is that we’ve seen an enormous amount of economic and policy uncertainty this year, but the US dollar has fallen, not risen. We can’t say why this is, but if it persists, as we suspect it will, it condemns the US dollar to a watery grave.

We are used to seeing periods of high uncertainty accompanied by significant US dollar strength. This is what we saw during the global financial crisis of 2008, the eurozone debt crisis between 2010 and 2012, Covid in 2020, and Russia-Ukraine conflict in 2022. All these periods saw high levels of fear and uncertainty amongst investors and notable US dollar strength, even if it proved temporary on some occasions.

However, so far this year, policy uncertainty has soared, and yet the US dollar has fallen. In fact, it seems that the more uncertain the environment becomes, the more the US dollar falls. This is an important change and, if it continues, it suggests that the US dollar might not be able to rely on that safe-asset support that has propped it up over many decades. But will it continue?

There might be a number of reasons why the correlation between uncertainty and the US dollar has broken down. The first explanation might be that the market feels that high levels of uncertainty, particularly policy uncertainty, have been created by bad policy in the US. Not just bad policy in the sense that tariffs are seen by most to be an economically regressive step, but also bad policy in terms of their rather chaotic introduction.

Other aspects of policy, such as the forced deportation of undocumented migrants probably elicit similar ‘bad policy’ feelings amongst investors, as does the passage of the budget. This makes it different from previous bouts of high uncertainty that we have seen, like Covid, which were not down to ‘bad’ US policy. Some would argue that the financial crisis was down to bad policy, but it seemed more a case of private sector overreach that the government implicitly allowed through weak regulation (although the same was happening in many other countries, notably the UK).

So, could perceptions of bad policy in the US account for the fact that the US dollar has gone down even though these policies have brought about the high levels of uncertainty that would ordinarily lift the greenback? This could be the explanation but Steven Barrow, Head of Standard Bank G10 Strategy prefer an alternative view. This view is based on the observation that sky-high uncertainty has not led to a significant tightening of financial conditions. And that’s unlike previous episodes, particularly Covid and the financial crisis.

In fact, the policy uncertainty is almost on a par today with what we’ve seen during these previous crises, but financial conditions, as measured by the US Treasury, are becalmed. Steven Barrow believes that the demand for US dollars during bouts of anxiety is not down to perceptions of good or bad policy but, instead, funding conditions. For instance, those that have borrowed US dollars to fund investment will often rush to pay them down in periods of high uncertainty and tight financial conditions, fearful that securing US dollars will become harder or more expensive.

This ‘dollar shortage’ problem has been eased by central bank FX swaps between the Fed and other central banks, and it does seem to be doing the trick, as more recent episodes of high uncertainty have not seen US dollar funding costs surge. Expanded central bank balance sheets may also be offering a cushion against a dramatic tightening of financial conditions.

Whatever it is, we can see that financial conditions such as credit spreads, funding costs, safe asset demand and more are not in the danger zone at all, far from it. And if global investors, firms and even individuals do not fear that this period of high uncertainty requires remedial action to quickly repay US dollar borrowing, it seems unlikely that the US dollar will surge. Of course, we can only speculate that this is the reason. If we are right, it suggests that those still believing that high uncertainty will lift the US dollar have to hope that financial conditions tighten significantly. But it could be a long wait.