An unprecedented appreciation in the value of the US dollar has been seen in 2022, with the $ strengthening around 20%. The reasons for the currency move are multifarious, however the usual contenders rank high among investor speculation. These include rising interest rates by the FED and the greenback commonly thought of as a 'safe haven' especially in times of volatility and uncertainty.
However, when we delve deeper into the current climate, we see there may be other idiosyncratic factors at play.
Traditional Factors
The so-called generic factors are still much at play as ever before.
Rising interest rates in the US means that 'hot money' flows into the US economy, as investors seek higher returns on savings. This means the demand for US dollars increases, and as a result the currency appreciates. With consecutive hikes seen by the FED recently, with no signs of cuts until July 2023 (as of 4 November 2022), we expect this trend to continue.
However, while in the past the US has been a 'flight to safety', we believe this is less of a driving force for the appreciation this time round.
It is believed a stronger force is behind the appreciation: need of non-US investors to buy dollars to cover losses on dollar assets or reduce hedges on these assets.
Hedging the Dollar
The US undoubtedly has accumulated a significant deficit of external financial assets vs liabilities, and attracted a lot of foreign capital. As of now, about $14tn worth of dollar-denominated bonds are owned by foreigners. Around half of this forms current account surpluses of other countries.
It is reasonable to assume much of this value is hedged, to protect against currency risk (exchange rate fluctuations). Especially during such uncertain climates, hedging positions is an essential tool. The style of hedging usually involves selling the dollar and buying-back home currency at a future date.
However, since the price of bonds have fallen with rising interest rates, what this means is that there have been significant losses. This involves reducing hedges down, so buying back dollars and selling home currencies.
Estimates suggest foreign investors have bought back around $700bn due to this reason, owing to losses from dollar-denominated portfolios. This number is likely the deterministic factor driving demand for dollars and causing the appreciation.
Implications for International Imbalances
Theoretically, it is expected the imbalance in the US would be lessened through a depreciation, which would occur if foreign investors became saturated with dollar risk from holding bonds.
However, the extent to which a Treasury on a hedged basis will be saturated with US risk is minimal, since the FED can always print money to pay its obligations (meaning it will not default) and the devaluation of the US $ due to excess printing is also mitigated through the hedging component. Therefore, countries will continue to accumulate more liabilities.
Imbalances will continue to grow, and this strains the financial system as balance sheets grow. They point to financial instability, particularly such as with high debt-to-GDP metrics.
The root cause of currency appreciation is by nature made up of a complex web of factors, and the implications for which is the driving force can be essential to decide a strategy to overcome the issues. The understanding of the US-hedging mechanism is essential to see past the dollar as a 'haven' and realise the impact on international imbalances. As these keep growing, due to US-debt build up, we need to contain the dollar deficit and depreciate the currency in order to reign in the deficit.