Fitch downgrade unlikely to threaten dollar supremacy

When rating agency Fitch downgraded the US government credit score last week, it highlighted some legitimate concerns over rising debt and a dysfunctional debt ceiling process—which leads to sporadic worries over a default. The agency observed an “erosion of governance” over the past two decades. Fitch expects government debt to rise to 118% of gross domestic product by 2025, compared to a median of around 39% for AAA-rated nations.

Both factors are unhelpful in sustaining the US currency's role as the linchpin of the global financial system. It also seems realistic to expect the landscape to become more diverse going forward, with several currencies and even commodities playing critical roles.

But we don't see an imminent threat to the US currency's status, and we expect to be living in a US dollar-centric world for years to come, for several main reasons:

• 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 tends to survive well past the peak of their influence. The latest International Monetary Fund 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.
• The US dollar continues to stand out as the world's most liquid currency. 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. The depth of the US Treasury bond market is second to none. The US dollar was on one side of 88% of all global currency trades in 2022, according to the Bank for International Settlements. It 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 appeals strongly to reserve managers and those involved in international trade.
• Stability and safety matter. For all the challenges the US financial and political system is experiencing, the country 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 assets with respect. The prospect of yet another federal government shutdown in October does not improve the country’s reputation, for instance.

So while competition for the dollar is rising, we don't see any leading rival to dethrone the currency in coming years. This was illustrated by the UBS Annual Reserve Manager Survey, conducted this year among almost 40 central banks from all regions. When asked which reserve currencies or assets are most likely to benefit from macroeconomic and geopolitical shifts over the next five years, reserve managers provided a wide range of answers—rather than a single competitor.

From a cyclical perspective, we expect the US dollar to weaken and are most preferred on the euro and the Japanese yen. However, 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 diversify their fixed income and equity holdings, or position in options or structured strategies that could deliver positive returns in the event of dollar weakness.