Will US dollar dominance continue to lift this currency?

At first glance, there seems to be an inherent contradiction in president-elect Trump’s views when it comes to tariffs, trade and the US dollar. On one side, there seems to be a clear desire to use tariffs to reduce the trade deficit. But on the other, tariff threats are also made to those that might ditch the “mighty US dollar”. In short, it seems as if Trump wants to maintain a strong US dollar and improve trade at the same time; something that seems incompatible unless, that is, tariffs can work some magic. But this might not be as mad as it seems as there is a key assumption being made here, which is that preserving the status of the US dollar (as the world’s leading currency) strengthens its value. But can that be taken as a given?

As we know, the US dollar is the dominant currency, a position it inherited from the pound as far back as the 1930s. And yet, the greenback has not experienced never-ending strength since then; there have been long periods of weakness.

Now, of course, currency dominance does not mean that the currency always rises; it means that the currency is stronger than it would have been in the absence of such dominance, which is not measurable. Nonetheless, are there reasons to feel that currency dominance is not all it is cracked up to be when it comes to currency strength?

One way to answer this is to think about those instances when we know, or at least are pretty sure, that US dollar dominance does lift the currency. These are periods of extreme global risk aversion when an adverse shock occurs, such as a pandemic or a global financial crisis. In these instances, the US dollar’s role as the key global funding currency leads to a potential shortage of US dollars. A shortage that central banks sometimes have to meet with central bank FX swaps. In spite of such actions, we normally observe US dollar strength during these periods and hence might argue that dominance does bring strength. But crises such as these happen very rarely. Might it be the case that, when the world is not in the midst of some sort of crisis, the ‘natural’ bias is US dollar weakness?

For if ‘crises’ lead to a shortage of US dollars, then ‘normal’ periods might be associated with a situation in which US dollar supply is plentiful, perhaps overplentiful. Another point to bear in mind here is that US dollar dominance arguably allows the US to outperform its peers in terms of things like growth and asset prices. It can do this because US dollar dominance creates a ready stream of foreign demand for US assets that allows the US to run bigger deficits than others, in trade, for instance, without the cost of significant vulnerability in currency or bond market terms. But US outperformance in asset prices can generate month-end and quarter-end portfolio rebalancing effects that weaken the US dollar.

In addition, the FX market is primarily a market where currencies are borrowed and lent (in the swaps market), not bought and sold (in the spot market). Mostly it is a case of US dollars being borrowed to fund other investments or other transactions. In effect, overseas investors are often not buying US dollars to invest in treasuries or stocks but borrowing US dollars in the swap market. Not only does it mean neutrality when it comes to the value of the US dollar, but the outperformance of US assets can also cause foreign holders to take profits in the spot market, and these US dollar sales can weigh on the value of this currency.

The Standard Bank said many, if not most, traders and investors would disagree with this argument that US dollar dominance need not mean a rising US dollar. But it is important to ask this question because the FX market just naturally assumes the US dollar dominance implies a rising US dollar without ever questioning why this might be the case. And, if this argument is right, then it might not be so strange to think that US dollar dominance can be preserved in the context of a weaker greenback - perhaps as Trump would like to see.