Market Thoughts: The dollar frowns

We’ve moved from headlines hustling de-Americanization to now de-dollarization. That escalated quickly. The dollar’s role as a reserve currency has been in gradual decline for decades, a byproduct of an expanding global economy post Bretton Woods. The dollar’s strength as a reserve currency is steadfast, but wavering.

I say that appreciative of how pervasively the dollar is used across markets. To put numbers around that, the dollar is involved in about 90% of all global FX transactions. Per the latest edition of the BIS Triennial Central Bank Survey, it’s the single most traded currency in the world.

If you take a snapshot of all U.S. dollar denominated assets held in official foreign exchange reserves, the IMF estimates it totals $6.5-7 trillion as of December 2024. For context, that number was about $1 trillion in 2000. Those are big numbers. But if you look at those same assets as a percentage of total foreign reserve holdings over that same 25-year period, we’ve seen a decline from about 72% to call it 58% currently.

Foreigners are estimated to hold around 30% of U.S. Treasury bonds and 20% of U.S. equities. U.S. exceptionalism literally quantified. Washington’s pivot to tariff ‘attack mode’ is accelerating a reversal in what had effectively felt like one-way inflows into U.S. markets. Threatening the Fed’s independence isn’t bolstering sentiment.

Japan is the single largest foreign holder of U.S. Treasuries, coming in at over $1 trillion. China comes in second at $780bn, followed by the U.K. at $750bn. To lend context to those figures, currently there are $29 trillion in U.S. Treasury securities held by the public. Should any of the three top holders decide to weaponize rapid fire sales it would send markets into a spiral.

The “dollar smile” is a framework used to contextualize how the dollar trades against currencies throughout a market cycle. The ‘north star’ for foreign exchange markets is interest rate differentials. They’re driven by monetary policy, inflation expectations and the global macro outlook.

The dollar tends to outperform when there is concern of global recession or event risk. It benefits from being viewed a safe harbor asset. Think of it as the left side of a widening smile in the face of a left tail exogenous shock. When U.S. economic and market exceptionalism prevail, the dollar outperforms also. The right side of the smile? Risk assets on the march higher, the dollar in tow.

Washington trade policy is today’s exogenous shock. The dollar isn’t a safe haven in that environment. Investors have been well paid to be overweight U.S. markets. As policymakers in Washington flirt with deflating U.S. economic growth and corporate earnings that have been well above trend, investors are trimming their overweights and stepping back to ‘take a beat’ on U.S. exceptionalism.

Even in the face of what had been rising longer dated U.S. Government bond market yields, the dollar has remained under pressure. In the current instance, interest rate differentials have been pushed aside for position unwinding of dollar denominated assets. The dollar frowns.

The ECB has obliged markets with another rate cut. Their mandate may be inflation, but their collective eye is on growth as trade talks drag on. The Bank of England meets in May, where I expect they will cut policy rates. They should, for the same reasons. I expect the Fed to remain on hold in May. Jay Powell reiterated that view again this week.

That mix of policy response should eventually calm the selloff we’ve seen in the dollar. Interest rate differentials leaning in to steady the pace of dollar depreciation. The known unknown in this: Will we see a stampede of foreign investors running away from the dollar and U.S. assets in favor of repatriating their funds?

This is one of the most challenging markets I’ve seen. It argues for ensuring you’re not over risked or too concentrated. That’s exactly how we are positioned. Well diversified, playing strong defense. Not overreaching for risk. I continue to believe we’re not being paid to lean in. Steady hands prevail.

Markets haven’t really been trading on fundamentals for about a month. In particular as it relates to single stocks. Absurdly high correlations are the proof statement. Investors are day trading momentum, selling what they can, slowly stepping back from risk taking. No one’s smiling, lots of frowns.