The dollar is the ultimate stress barometer

Article about The dollar is the ultimate stress barometer

Jun 9, 2020

Perfect barometer

At the turn of the year, one could get 1.12 dollars for one euro. In the last week of February, the corona crisis also spread to Europe and later to the United States. However, in March, at what must have been the low point of the crisis in retrospect, the dollar had risen to 1.06 against the euro. European investors in US assets saw the value of their investments decline, but the rise in the dollar somewhat eased the pain of the losses incurred. In the fourth week of March, however, the stock markets began a recovery that continues to this day. Meanwhile, the biggest losses have disappeared. The dollar is back at the level of the beginning of this year, 1.12. Once again, the dollar has proven to be the world's most important refuge in times of turmoil in the financial markets. Even more than gold, silver, the Japanese yen or the Swiss franc, the American currency is a perfect barometer for the temperature on the financial markets.

Biggest capital market

The reason for this is known. The American economy is still the largest in the world. But even more than that, the U.S. capital market is by far the most important in the world economy. For example, American shares make up as much as 65 percent of the MSCI World Index. There is not a country in the world that comes anywhere near it. More important, however, is the market for U.S. government bonds. If you are the largest economy in the world, you soon have the largest government debt. Without any competition, the market for US Treasuries is the most extensive and liquid market in the world. And partly for that reason also very popular with large professional investors when they want to put an amount of money safely away. Entering and exiting can be done for relatively little risk and at low cost.

Key currency

In the hierarchy of global investment, bonds are more important than equities. Even more important, however, is global currency trading. After all, that is where the largest amounts of money go. And you guessed it, the dollar is without any competition the most important currency on this earth. The worldwide use of dollars is almost five times as high as the actual share of the United States in world trade. So the dollar is also used outside the United States as a trade currency. The dollar is considered the key currency worldwide. This gives the United States its enormous economic power. It enables the United States to get deeply into debt - Greeks and Italians would pale into insignificance - and pay the bill to the rest of the world.

Huge dollar debts

This omnipotence of the dollar has also contributed to the fact that governments, banks and companies worldwide have financed huge amounts of their outstanding debts in dollars. Not only many emerging economies from the former Third World have a large part of their debts outstanding in dollars, but also many European companies and banks. After all, the dollar is much more reliable than their own currency, not to mention the euro. This heavy burden of debt in dollars always causes tensions on the markets in times of great financial turmoil. Banks and companies stumble over each other in times of crisis in their demand for dollars that their own central banks do not have enough in stock. Without a helping hand, many banks and companies would have collapsed during the previous crisis.

Lender of the last resort

That helping hand came from the U.S. Central Bank. After all, the Federal Reserve is the only one that has enough dollars at its disposal. And in case of a deficit, the central bank can easily print some new dollars. Something that happens on a large scale. Also during the current crisis, the Federal Reserve acted as the lender of the last resort. It provided other central banks with the necessary dollars via quickly set up swap lines. Dollar debts could be paid in this way without too high costs. In this way, the financial system could continue to function. Calm returned to some extent and the markets recovered. Meanwhile, investors could worry about easing the lockdowns and the time needed for a vaccine against Covid-19.

Outside category

However, this crisis made it even more clear than the previous one that there are many central banks in the world, but there is one of the outside categories. The governor of this central bank not only has to deal with a fickle president, but also has an exceptional responsibility: to keep the global financial system afloat in stormy times. It is the ultimate consequence of the dollar's key position in the global economy. For investors, it has become clear again in recent months, if there is one barometer of the temperature of the economy it is the dollar. The gradual decline of the dollar in recent weeks is a good sign.

 


Articles authored by Robert Jan Teuwissen

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