Oscar Wilde was the author of 'The Importance of Being Earnest'.
It's probably his most important play, and one that has endured nearly 130 years at the West End.
Which is about the same time that the dollar has had its dominance too.
What we're going to talk about today is why the dollar reigns supreme in more detail, rather than simply saying it's down to the credit infrastructure of the world, which while being true, doesn't give the full colour.
Ask all questions in the Discord or via email!
What is the Eurodollar?
No, it's not EURUSD.
A Eurodollar is an unsecured USD deposit held outside of the U.S.
They are not under the US’ legal jurisdiction, nor are they subject to US rules and regulations.
Eurodollars are called Eurodollars purely because they were largely held in European banks in the beginning, although now they're held all over the world.
Really, it's post WW2 that Eurodollars started to really become important.
The post-war boom led to more trade occurring with other countries, which naturally would mean swapping dollars for the goods...
And that means non-US countries having a requirement to hold USD.
Take China for example.
The US runs a deficit with them, so what do the Chinese do with all of those dollars?
They buy US treasuries to keep their dollar balance in a AAA rated debt instrument.
Let's think back to March.
We had a big rush for everyone to hold USD to be able to fulfil transactions.
And what did the Fed do?
They had to open swap lines to allow global economies to function.
The role of the Fed in the Eurodollar market as the institution which can print at will makes the Fed the overriding force in the world.
The Eurodollar system has no ability to create dollars when it wants, so the Fed (and more broadly, the US) has to step in.
A problem is created here then.
The US must keep dollars flowing out of the US to satisfy global demand through trade and transactions.
And this means running capital account or current account deficits.
Either lending ex-US or spending.
So rather than thinking running deficits is a net-bad thing, it's actually by design to be able to maintain dominance.
It's a double edged sword, though.
See, with money flows out, you get a loss of manufacturing jobs, industry and other problems which may undermine this dominance.
In essence, the Eurodollar system functions via geopolitical means and not necessarily by financial design.
But its largest strength is relative.
What is the alternative?
Would you like to transact in Euros, or Yuan?
'Fundamentally, the Eurodollar system is always short USD, and any loss of confidence sees everyone scramble to access them at once — in effect causing an invisible international bank run. Indeed, the Eurodollar market only works when it is a constant case of “You-Roll-Over Dollar”.' Michael Every, Rabobank.
As mentioned above, and how we saw early this year, the Fed had to step up to the plate to allow the world to access USD - not Euros, not Yuan - not gold or Bitcoin.
See, we don't want to move away from USD at all.
Well, especially China.
The data is naturally only until Q1 2019, but we can see the trend.
It's firmly up - and that means that dollars have to flow to these regions to finance the issuance.
Here's an article from this week from Bloomberg...
At the same time, euro and yen issuance is also increasing, so perhaps rather than being simply a dollar story, it is a broader market theme.
That doesn't displace the fact that USD is still seen as a desirable and required currency to deal in globally.
The Fed may face a conundrum, though.
All of these external liabilities have to be financed.
And in the real economy, not simply the financial market economy.
If we go back to what the US is forced to do in this case, which is increase the capital account or current account deficit, then we see that it's probably pretty likely that they will spend heavily (as they are doing) to match the pace and size of the Fed's balance sheet increases.
What does this mean for us?
We must always focus on what the dollar is doing.
That tends to be where I start with any thesis.
And this means looking at two things in tandem, one more of a discretionary model, and the other is the chart I always ask Rex for, FRAOIS.
Both do tend to run hand in hand, though.
Above is a chart of the dollar smile.
I mentioned FRAOIS and the dollar smile can go hand in hand because of one side of the equation - the risk off side.
Back in March, the FRAOIS indicated a dollar liquidity drain.
Just as explained above about the Eurodollar mechanism, the market absolutely demanded USD.
By focusing on on the macro elements we can try to deduce why there might be stresses in the dollar market, not necessarily to the extent of back in March, but certainly to piece together a view on future points in time as to when and why the market might become thin.
So when do people really need dollars?
Well let's start with the US government.
When they want to spend, the Fed has to now print.
As Kaplan put it back in October 2019...
“The dramatic increase in Treasury issuance takes liquidity out of the system. That I think is at the top of the list for reasons we need more liquidity.”
If the Fed don't match this, then obviously there is less USD liquidity, which is probably the reason why everyone is expecting QE to happen in December if a fiscal stimulus package is to go ahead.
The US Treasury sells bonds and bills when they need to raise cash, and primary banks use their excess dollar reserves to purchase these.
That's how liquidity leaves the banking system.
At a time when bank reserves are low and the Treasury is demanding cash, this is likely to cause funding issues as these excess reserves parked at the Fed are replaced with 'high quality assets' at primary banks, rather than USD.
So what might we gather from that?
Well, if a stimulus deal is announced, the trade might be to be long the dollar versus Asian currencies, specifically the yen if we are to believe that the BoJ and Japanese government want a weaker yen.
Alongside this, Japan has so far been rather unscathed from the virus, meaning they are unlikely to stimulate as much as the US would, which could provide some kind of differential there on growth prospects, although they did grow at a better pace than expected just recently.
We could also look to add a case to our USDCHF thesis here as well.
Here's a recap of that view.
There is also a case to be looking at being bearish gold, especially if we do see a rise in yields going forward.
I would be less inclined to believe that there is an inflation hedge trade still apparent in gold, and would argue that it could be priced in already.
Let's bounce these ideas about in the Discord, but remember, always keep USD at the centre of your view.