By Mike Dolan
LONDON (Reuters) -The latest rise in the U.S. dollar has forced central banks around the world to lean against it, selling dollar reserves to stabilize the local currency but also potentially overstating the dollar’s strength and sowing trouble down the road.
If hard cash reserves, typically housed in US debt, are cut sharply, it could only push up Treasury yields further at the margins and reinforce one of the key reasons for the dollar’s strength in the process. Until tighter Treasury yields eventually drive foreign capital out of “exceptional” US markets in general, the process could spiral from here.
The Federal Reserve’s “hawk-like cut” on Wednesday provided the final boost to the dollar by forcing markets to reconsider the interest rate horizon next year and on suspicion that the Fed’s new 4.38% policy rate may not work in the current cycle will fall below 4%.
As US Treasury yields rose on both this hawkish message and the Fed’s higher inflation forecasts, the dollar moved right along with them – which many major emerging markets, which still rely on significant dollar financing and fear promised rate hikes from a Donald Trump, rose with them. Trump White House, in disarray.
The Fed’s own broad trade-weighted index – which has risen nearly 40% over the past decade – is again approaching 2022 record highs, with the inflation-adjusted ‘real’ index also less than 2% off all-time highs .
The latest turn has proven especially painful for many emerging economies, with many countries facing both looming trade threats and domestic crises.
Brazil is a highlight, where the real has lost more than 20% of its value this year and 12% of that in the past three months. The country has been hit by mounting budgetary concerns, even despite a 100 basis point rate hike from the central bank this month. .
The currency shock has forced the central bank to intervene on the open market, selling $5 billion in a surprise second auction on Thursday – the largest of its kind since Brazil’s currency floated in 1999.
The central bank has held six spot interventions since last week, selling a total of $13.75 billion, in addition to three dollar auctions involving repurchase agreements of $7 billion.
But Brazil is far from alone.
Exaggerated by a recent government crisis, the South Korean won has fallen to a 15-year low, while the Indian rupee hit a record low and the Indonesian rupiah hit a four-month low.
All three central banks actively sold dollars on Thursday, along with strong verbal warnings of further action.
China, which holds the world’s largest stockpile of hard cash and is the second-largest holder of government bonds, is suspected of also selling dollars on Thursday to support the yuan’s slide to a 2024 low.
According to JPMorgan, capital outflows from emerging economies excluding China amounted to around $33 billion in October alone. Including China, this amounted to $105 billion – the largest monthly outflow of money since June 2022, just before the US elections.
While flows stabilized just ahead of this week’s Fed meeting, pressure has now clearly returned heading into year-end.
“We could be moving toward a new equilibrium — one in which emerging market portfolio flows could struggle,” JPM analyst Katherine Marney told clients.
US LIABILITIES BALLOONS
But will it still matter for Treasuries if emerging market central banks pull back, with less demand for US debt or even outright sales of notes and bonds?
Together, entities from China, Brazil, South Korea and India account for approximately $1.5 trillion in overseas government bonds.
That may seem small against a total of $28 trillion in outstanding marketable government bonds. Moreover, these figures may flatter official assets, and the dollars sold in interventions may not necessarily lead to a reduction in debt securities.
But these countries are probably not the only ones selling dollars as part of the new rally, and the size of any blow could still negatively impact demand for government bonds at a sensitive time.
With US debt and budget concerns already high surrounding an incoming Trump administration and the Fed, any additional stimulus to government bond yields would only increase the pressure.
The more US Treasury yields rise, the higher the dollar will rise, and the overall heat in US markets could start to strike fear into the rest of the world, which has now invested so heavily there.
Perhaps the big question next year will be the extent to which rising Treasury yields will ultimately puncture the expensive and overcrowded US stock market. That could undermine the huge overseas inflows into the “exceptional” United States of the past decade and inflate the overvalued dollar.
That overwhelming foreign demand for U.S. securities and the massive outperformance of U.S. stock prices and the dollar in recent years will push the U.S. net international investment position (NIIP) to a $22.5 trillion deficit by mid-2024, it shows from the latest figures.
That is now about 77% of GDP – twice as much as ten years ago.
U.S. liabilities increased by $1.4 trillion to a total of $58.52 trillion, primarily due to rising U.S. stock prices that increased the value of portfolio investments and direct investment obligations.
But some $391.1 billion in additional foreign purchases of U.S. stocks and long-term debt securities contributed to the increase in liabilities.
Overall, portfolio investment obligations increased by $666 billion to $30.89 trillion and direct investment obligations increased by $568.2 billion to $16.64 trillion, mainly driven by gains on Wall Street.
All of this has probably expanded further since June.
The high US dollar and Wall Street rates – and the seemingly ubiquitous optimism about the 2025 outlook – mean that any disruption to capital flows and exchange rates at this stage could trigger a dangerous and largely unforeseen market reversal on a large scale.
The opinions expressed here are those of the author, a columnist for Reuters.
(by Mike Dolan X: @reutersMikeD; editing by Sam Holmes)
