How does the risk aversion impact USD?

The dollar usually rises when risk aversion soars.

The dollar usually surges when risk aversion vaults higher because dollar borrowers rush to repay dollar loans fearing that either the cost of securing dollars will rise or their access to dollars might be cut off altogether. Given that international non-bank borrowing in dollars is three times that of the next closest currency, the euro, and five times if we look at just borrowers from emerging market countries. It is clear that it is the greenback that borrowers rush back to more than any other currency. And it is this that tends to lift the dollar when risk aversion increases.

If we were to go back over time and add up all the occasions that the dollar was boosted by these safe-haven effects, they would account for much of the dollar’s strength that we have seen over time. Or, put another way, without these periods of significant dollar strength, it is likely that we would have had a much lower dollar on average. Of course, there are some qualifications we need to add in here.

The first assumption is that any dollar strength following one of these risk-off episodes is not more than offset by weakness as risk aversion declines again. In other words, we assume that the risk-off event produces a net positive effect on the dollar once we take into account both the initial surge and any subsequent short-term correction lower.

Secondly, we are assuming here that any longer-term dollar weakness that might result from the long periods of low and/or falling risk aversion does not effect a slide in the dollar that more than offsets the greenback’s strength that occurs through the risk-off periods. If both of these assumptions are correct then it seems reasonable to conclude that risk-off episodes are a net benefit to the dollar over time and that, without them, the dollar would be lower.

While this might seem an academic point, it is not without relevance because it seems that the dollar’s sensitivity to increased risk aversion has diminished. US policymakers certainly have an interest in seeing it diminish for three main reasons. The first is that the impact of an adverse shock, like the global financial crisis can be magnified by a dollar shortage problem, and that’s negative for the US economy. Secondly, a surge in the dollar reduces the value of US assets held abroad, so worsening the, already huge deficit in the net international investment position (NIIP). And thirdly, a dollar surge can damage trade and so undermine one of the potential recovery mechanisms after an adverse shock has occurred. All told, US policymakers have an incentive to supply sufficient dollars during such risk-off episodes that runs far deeper than just aiding foreign economies.

“To this end, the Federal Reserve has been increasingly utilising central bank swaps and treasury repos to supply sufficient dollars and, if we look at a measure of dollar borrowing costs, such as cross currency basis spreads, we see that the policy seems to have worked during the pandemic. A corollary of this is that the rise in the dollar through the early stages of the coronavirus crisis was both very modest relative to earlier risk-off events and came to an end very quickly. Now clearly this does not guarantee that Fed access to dollar liquidity will always work so effectively in the future, but we do think it is an important sign that dollar borrowers can feel a little more comfortable that dollar shortages won’t happen to the same extent as in the past. That might actually give borrowers a bigger incentive to use the dollar but could come at a cost of a lower value of the dollar on average as these borrowings are sold for other local (or even non-local) currencies”, Mr. Steve Barrow, Head of the Standard Bank G10 Strategy said.