The USD index is heading for a retest of three-year high at 103 level and currency markets may be rightly asking themselves a question about how overvalued the American currency is and is there fuel in the tanks to extend the rally. In this article, I substantiate strong dollar by the action of two temporary factors that overlapped each other in March but should start to fade this month.
1. Liquidity crunch
This term is quite broad, and its use has increased lately, however it needs clarification in order to understand exactly how it could affect dollar value and why we can expect this factor to recede.
One of the aspects of lack of liquidity that comes to mind and that has been discussed hundreds of times is the recent dysfunction of US repo market which could finally transform into a full-fledged crisis. However, I want to draw your attention to another market of non-financial commercial papers, which looks like a more suitable candidate for making guesses about causal relationships.
On this market US firms can directly borrow to cover short-term liabilities by issuing uncollateralized securities that do not require registration with the SEC. Below is an interest rate chart for commercial papers issued by firms with AA rating and maturity of 90 days. Starting from about March 10, the rate began to grow rapidly, i.e. the cost of borrowing for companies has risen sharply:
Here is some important facts about this chart:
- At the time when Federal Reserve was treating the repo market dysfunction, supply on CP market was quite stable and grew (which can be seen from declining interest rate).
- The market demonstrated normal response to the emergency Fed rate cuts (as can be seen from the CP rate drop in early March which followed FFR drop).
- Investors, apparently, fled in mid-March, and then the global hunt for the dollar began:
Should we expect stabilization of the market and return of the rate to a comfortable level? Yes, we can because the Fed announced direct intervention in the market through the special credit facility (Commercial Paper Funding Facility), which starts to work in the first half of April.
2. Outflow from emerging markets
The outflow of capital from EM in March was the highest in history and easily exceeded even post-GFC EM rout:
Since January 21, the outflow amounted to almost $ 100 billion, while in the same 2-plus month after the 2008 recession, investors repatriated about only $ 30 billion. They returned to emerging markets shortly after the Fed launched QE and extremely fast policy response of the Fed and the government this time paves the way for even quicker rebound in sentiments. The basic scenario is now the suppression of the Covid-19 outbreak by summer, so April will likely be a transition period for the dollar in terms of demand for EM assets.
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