King Dollar
The US dollar wields considerable influence over the global economy, and its position has solidified over the past decade
In 2008, in the throes of the financial crisis, the US Dollar Index appreciated more than 20%. Even though US banks were failing, and the country’s financial system was under considerable stress, investors still flocked to the US dollar and dollar-denominated debt. Figure 1 shows how the dollar index climbed while the S&P lost more than 50% in 2008.
Figure 1: Dollar Index, S&P 500 through Great Financial Crisis
Source: S&P Capital IQ, Thomson Reuters Datastream
Two features tend to guide investor perceptions of safety: liquidity and fundamentals. US Treasurys offer more depth than any other market for government debt, and the US economy remains the strongest in the world. And while one might have expected the dollar to mean revert downward as the Federal Reserve lowered interest rates and increased the money supply, the opposite happened, and the Dollar Index stands some 12% higher today than it did at its peak in 2009. The financial crisis demonstrated the power of the dollar while simultaneously damaging the reputation of the most likely potential alternative, the euro.
By making use of a massive database from Morningstar, Matteo Maggiori, Brent Neiman, and Jesse Schreger highlight that the share of dollar-denominated cross-border holdings has surged since 2008. Figure 2 shows that while the US dollar was the currency of denomination for 41 percent of global cross-border holdings of corporate debt in 2005, the euro accounted for 38 percent. Following the financial crisis of 2008, the euro’s share dropped to 22%, while the US dollar’s share rose to 63%.
Figure 2: Cross-Border Holdings of Corporate Debt, USD and EUR
Source: Maggiori et al.
Globally, corporations continue to turn to the safety and stability of the US dollar for financing. Investors are willing to pay to own safe US dollar-denominated bonds. In a new paper out of Stanford University, authors Zhengyang Jiang, Arvind Krishnamurthy, and Hanno Lustig estimate the size of this premium to range from around 0.2% during normal times to over 1% during times of crisis. Figure 3 shows the yield spread between the one-year US Treasury and one-year foreign government bonds, the average US-foreign spread for investment-grade corporate debt with maturities of 1-3 years, and the average US-foreign spread for investment-grade corporate debt with maturities of 1-7 years.
Figure 3: Yield Spread between Foreign and US Government & Corporate Debt
Source: Jiang et al.
US Treasurys and US corporate debt have lower yields (up to 1% lower) than their foreign counterparts, even when adjusting for exchange rate differentials. This differential, the authors argue, offers empirical support for the idea that the US functions as a global financial safe haven. As the data show, the yield spread increased in 2008, in the middle of the crisis. This suggests that US and US-denominated safe assets have an anti-fragile property: in a crisis, the value of the US asset base rises relative to foreign countries.
The investors that will pay the greatest premium for US dollar assets are those who live in emerging markets. And we have historically seen flights to the dollar when emerging markets experience vulnerabilities. While a strong US dollar typically boosts exports for emerging countries, this benefit is more than offset by the impact felt by firms carrying US dollar-denominated liabilities. Specifically, increases in the US dollar exchange rate create a balance sheet mismatch for foreign issuers of US dollar-denominated debt. The impact of a dollar-heavy capital structure becomes particularly acute during crises: debt burdens increase in relative value as output drops.
In short, because the dollar is the world’s primary source of funding, the strengthening and weakening of the US dollar can pose a risk for economies across the globe. Figure 4 shows a negative relationship between the Dollar Index and the MSCI Emerging Market Index. The EM bull market of 2001–2008 corresponded with a -40% depreciation in the US dollar.
Figure 4: MSCI Emerging Markets Index, Dollar Index, Dec. 1987 – Present
Source: S&P Capital IQ, Thomson Reuters Datastream
Since 2008, the US dollar has appreciated, and emerging markets have stagnated. As we identified in our EM crisis investing white paper, there have been 71 crisis events in the 18 most liquid markets since 1987. The US dollar-driven global financial model of Jiang et al. helps us understand not only why emerging market economies underperform but also why they experience substantial volatility. The authors note that when a country reduces its supply of dollar claims, the dollar exchange rate appreciates, creating further losses to other foreign countries’ dollar borrowers. In this way, a shock in one market propagates to dollar balance sheets in other countries and volatility spreads.
As firms around the world turn to the safety of the dollar as a funding source, movements in the dollar result in constant revaluations of global debt burdens. When the dollar strengthens, the liabilities of foreign firms become more onerous. And when the dollar weakens, these liabilities become more manageable. In this sense, in the same way that the high-yield spread measures liquidity conditions for domestic US companies, the value of the dollar can be interpreted as a measure of liquidity and risk appetite globally. We’ve found that the best way to capture the volatility associated with the changes in global liquidity is through a systematic short on emerging market currencies.
As of now, the economic incentive for both US and foreign firms to supply dollar assets remains quite strong. And given that liquidity is a primary feature of safety, it is unlikely we will see any suitable alternative to the dollar emerge any time soon.