Author: Mike Dolan
LONDON (Reuters) – The recent rise in the U.S. dollar has forced central banks around the world to lean on it, selling dollar reserves to stabilize local currencies but potentially increasing the dollar’s strength for opportunities and sowing problems down the road.
If reserves of demanding cash, typically held in U.S. debt, decline sharply, it could only worsen Treasury yields on higher margins and thus reinforce one of the main causes of the dollar’s strength. Until the tightening of Treasury yields finally forces the withdrawal of foreign capital from the “exceptional” American markets in general, this process may gain momentum.
The Federal Reserve’s “hawkish cut” on Wednesday provided further stimulus for the dollar, forcing markets to rethink the horizon for next year’s interest rates and suspicions that the Fed’s fresh policy rate of 4.38% may not return this cycle. below 4%.
As U.S. Treasury yields rose in response to both the hawkish message and the Fed’s higher inflation forecasts, the dollar went with them, shocking many major emerging markets still dependent on significant dollar financing and fearing tariff hikes promised by the Donald White House Trump.
The Fed’s own broad trade-weighted index – up almost 40% over the past decade – is again at record levels set in 2022, with the “real” inflation-adjusted index also less than 2% below all-time highs.
The recent turn has been painful, especially for many emerging economies, with many of them coping with both grave trade threats and domestic crises.
Brazil stands out – where the real has lost more than 20% of its value this year and 12% in the past three months – hit by growing budget concerns even as the central bank raises interest rates by 100 basis points this month.
The currency shock forced the central bank to intervene in the open market, and on Thursday it sold $5 billion in a surprise second auction – the largest of its kind since Brazil’s currency was introduced in 1999.
Since last week, the central bank has conducted six spot interventions, selling a total of $13.75 billion, in addition to three dollar auctions with repurchase agreements worth $7 billion.
But Brazil is not alone.
Exaggerated by the recent government crisis, South Korea’s winnings fell to a 15-year low, the Indian rupiah hit a record low and the Indonesian rupiah hit a four-month low.
All three central banks actively sold dollars on Thursday, while giving verbal warnings about further actions.
China, which has the world’s largest stockpile of demanding cash and is the second-largest holder of government bonds, is also suspected of selling dollars on Thursday to shore up the yuan’s decline to 2024 lows.
According to JPMorgan, capital outflows from emerging economies excluding China amounted to about $33 billion in October alone. Including China, it was $105 billion, the largest monthly outflow since June 2022, just before the US elections.
Although flows stabilized just before this week’s Fed meeting, pressure clearly returns towards the end of the year.
“We may be entering a new equilibrium – one in which portfolio flows in emerging markets may be difficult,” JPM analyst Katherine Marney told clients.
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But will it still matter to Treasuries if emerging market central banks pull out, reducing demand for US debt or even selling notes and bonds altogether?
Collectively, entities from China, Brazil, South Korea and India hold foreign portfolios of Treasury securities worth approximately $1.5 trillion.
This may seem miniature compared to the $28 trillion total value of Treasury tradable securities. Moreover, these listings may be flattering to official holdings, and the dollars sold in the intervention may not necessarily include analysis of debt securities per se.
But these countries are likely not the only ones selling dollars in the fresh surge, and the scale of the overall hit could yet weigh on demand for Treasuries on margin at a sensitive time.
Given that U.S. debt and fiscal concerns are already high with the incoming Trump administration and the Fed, any additional boost to Treasury yields will only add to the pressure.
The more Treasury yields rise, the higher the dollar will go, and the general warming in U.S. markets could begin to spook the rest of the world that currently invests so heavily there.
Perhaps the biggest question next year will be the extent to which spiraling Treasury yields will ultimately outperform the costly and crowded U.S. stock market. This could undermine the massive influx of foreign immigrants into the “exceptional” United States over the past decade and inflate the value of the dollar.
According to the latest data, this overwhelming foreign demand for U.S. securities and the overwhelming outperformance of U.S. stocks and the dollar in recent years have pushed the U.S. net international investment position (NIIP) to a deficit of $22.5 trillion by mid-2024.
It is currently approximately 77% of GDP – twice as much as 10 years ago.
U.S. liabilities increased by $1.4 trillion to a total of $58.52 trillion, mainly due to rising U.S. stock prices, which lifted portfolio and direct investment liabilities.
However, additional foreign purchases of approximately $391.1 billion in U.S. equities and long-term debt securities contributed to the enhance in liabilities.
Overall, portfolio investment liabilities increased by $666 billion to $30.89 trillion, and direct investment liabilities increased by $568.2 billion to $16.64 trillion, mainly driven by gains on Wall Street.
All of this has likely expanded further since June.
High US dollar and Wall Street prices – and seemingly ubiquitous bullishness about the 2025 outlook – mean that any disruption to capital flows and exchange rates at this stage could trigger a threatening and largely unpredictable large-scale market reversal.
The opinions expressed here are those of the author, a Reuters columnist.
(Writing by Mike Dolan X: @reutersMikeD; Editing by Sam Holmes)
