When the coronavirus crisis began in earnest, investors the world over rushed to get their hands on U.S. dollars: The trade-weighted dollar index (“broad” index) rallied more than 8 percent between March 4 — when the U.S. stock-market selloff began — and March 23, when equities bottomed. A heightened need for short-term funding, as well as a global move out of risk assets, so increased demand for the greenback that investors warned of a “dollar shortage.”
Then began the pullback. Aggressive Federal Reserve measures stabilized financial markets, turning the shortest bear market in history into a rally. Since its May 14 high, the dollar has fallen by nearly 5 percent on a trade-weighted basis, among the sharpest two-month declines in modern history. Improvement in the global growth outlook has pushed capital out of the U.S. and into riskier markets, leading Wall Street analysts to predict a further decline in the broad dollar index of roughly 3 percent.
Thus have economists and investors gone, in a matter of months, from worrying about a dollar shortage to worrying about a dollar glut. A TD Securities analyst summed up the new consensus in Reuters, saying that “the dollar is hanging by a thread.” A Financial Times story echoed that sentiment, arguing that the “U.S.’s deepening Covid-19 crisis sent the US dollar tumbling.”
Far from a sign of the U.S. economy’s weakness, however, the dollar’s recent depreciation reflects the success of policymakers in combating the economic fallout from the pandemic.
In March, as the shock set in, businesses and governments scrambled for liquidity. Because roughly half of all international debt securities and cross-border loans ($22.6 trillion) are dollar-denominated, governments, banks, and corporations around the world need dollars to meet their financial obligations. To that end, they unloaded assets to get cash, leading to a sharp appreciation in the greenback.
The rush for dollars threatened to wreak havoc on the economy. If companies were unable to obtain short-term funding, mass insolvency would follow. With many sellers and few buyers in securities markets, liquidity evaporated from the financial system, even in the deepest, most liquid market: that for U.S. Treasury securities. As foreign and domestic banks sold U.S.-government bonds, the Treasury market experienced a brief meltdown, with yields more than doubling in early March. The dollar shortage persisted until the Fed stepped in and initiated $70 billion of daily Treasury purchases, along with similar interventions in the commercial-paper and repurchase-agreement markets.
Meanwhile, the Fed increased the number of central-bank swap lines — the facilities through which it lends dollars to foreign central banks — from five to 14, acting as lender of last resort to most of the world’s major economies. This unprecedented cross-border liquidity provision shored up the balance sheets of banks and non-bank financial institutions around the world.
The cumulative effect of these measures, in addition to stabilizing the financial system, was dollar depreciation: Increase the supply of a currency, and its value will decrease. As liquidity conditions stabilized, market participants began to unwind their dollar holdings. Meanwhile, a rally in equities and bonds decreased the relative attractiveness of cash. Rather than reflecting public-health-policy failures, as some commentators have suggested, the dollar’s depreciation caps a successful effort to stabilize the global financial system.
Low interest rates play a role, too. With the real yield on 10-year Treasuries at -0.9 percent, its lowest level since 2012, investors have looked to gold and silver as an alternative store of value. But low interest rates and increasing inflation expectations, too, are a positive sign. The principal challenge for central bankers in recent years has been to gain policy traction at the effective lower bound for interest rates. Moderate dollar weakness indicates that central bankers succeeded in loosening credit conditions amidst global panic. That investors continue to lend to the U.S. government despite historically low rates only accentuates the widespread faith in the dollar-backed financial system.
And the dollar can only slide so far. Even as the global economy shows early signs of a recovery, demand for dollar-denominated debt is likely to rise as emerging-market governments fund pandemic-relief programs and weather the storm of the recession. Export-dependent nations, especially those that rely on commodities such as oil, will likewise have higher funding needs for the foreseeable future. And when the ink dries on the European Union’s recent debt-mutualization plan, investors may be less sanguine than they are now, potentially bringing the euro back down to earth. Meanwhile, the strength of domestic asset markets will likely spur portfolio inflows that will offset downward moves in the dollar.
So don’t misinterpret the dollar’s recent slide as an indictment of the U.S. economy as a whole. In stabilizing the global financial system, the Fed no doubt strengthened the case for continued use of the dollar as a global reserve currency. As always, accommodative monetary policy carries a risk of excessive inflation, but in an environment of secular low inflation rates, that risk remains remote. Low Treasury yields and stronger global growth prospects may lead to dollar depreciation, but it is depreciation by design.