- Global currency regimes are sticky: The US dollar dominates financial markets and international trade. Changes in the world’s dominant currency have historically taken a long time to materialize. Even as great economic powers rise and fall, their currencies’ reserve status tend to survive well past the peak of their influence. The latest IMF survey on the currency composition of global foreign exchange reserves reveals that the share of US dollars held by central banks still stands at almost 60%. The greenback is also used in over 40% of every global payment and dominates 85% of trade finance contracts, according to SWIFT.
- Liquidity is king: Liquidity ranks at the very top of the properties that global reserve managers and those involved in international trade look for in a currency. The US dollar remains the world’s dominant currency in this realm. It was on one side of 88% of all trades in 2022, according to the BIS. It also remains solidly in first place when it comes to derivatives such as forwards, swaps, and options. This is relevant since the ability to hedge exposure to a given currency through derivatives constitutes a strong appeal to reserve managers and those involved in international trade.
- Stability and safety matter: For all the challenges the US financial and political system have experienced of late, the US still ranks highly in various gauges including rule of law; regulatory quality and efficiency; and market openness (the prevalence of capital controls, for example). As a result, the US continues to attract large flows of foreign investment. Of course, the US must treat the privilege of being able to issue the world’s preeminent currency with respect. Developments around the debt ceiling saga have the potential to severely affect trust in the US system. For more information, see our recent piece Government bonds: Another debt ceiling debate .
- Geopolitics enter the equation: Although shifts in the global currency order typically take place at a glacial pace, rising geopolitical tensions can trigger quicker adjustments. China, for instance, is working to accelerate the yuan's internationalization as relations remain tense with the US. Although these efforts are unlikely to yield overnight success, they plant the seeds of a more diversified currency landscape ahead.
- Gold has become the diversifier of choice: Last year saw very strong central bank buying of gold following Russia’s invasion of Ukraine, marking the 13th consecutive year of net purchases and the highest level of annual demand on record dating back to 1950. As the yellow metal carries no credit or counter-party risk, some central banks may deem it as being better insulated from financial sanctions.
Conclusion and investment implications
All in all, we think the dollar's reign will live on. At the same time, it will likely make some room for competitors along the way.
From a cyclical perspective, we expect the US dollar to weaken as the US growth and interest rate premium relative to the rest of the world erodes in the coming months. It is important to note that our call for a weaker US dollar in the near future is not based on the assumption of a declining global currency status.
With this in mind, we recommend investors to diversify their dollar cash or fixed income holdings, reduce allocations to US equities, or position in options or structured strategies that could deliver positive returns in the event of dollar weakness. On a relative basis, we prefer the Australian dollar as well as the Swiss franc, euro, pound, and yen.
We also see gold as an attractive portfolio diversifier and target a price of USD 2,200/oz over the next 12 months. Higher investor confidence that the Federal Reserve is approaching the peak in interest rates should bolster demand for the yellow metal. We also see official sector demand remaining strong for at least another year. In addition, gold has a good track record as a hedge against historical episodes of financial stress.
For more information, please see our recent piece Toward a more diversified, yet still US dollar-centric, global currency order .
Read the original report The dollar is dead; Long live the dollar 11 April 2023.
Main contributor: Solita Marcelli and Alejo Czerwonko
This content is a product of the UBS Chief Investment Office.