Central Banks Diversifying Away from Greenback

A Bloomberg headline tonight is uncharacteristically alarmist: “Dollar Reaches Breaking Point as Banks Shift Reserves.” However, while the article is correct to point to lack of enthusiasm for the dollar, it presents, but then fails to integrate, a key point: foreign central banks are not cutting dollar holdings. In fact, they are still increasing buying dollar assets. But they have shifted their marginal purchases in favor of the euro and yen. That shift is playing into current dollar weakness.

We could be approaching a short-term inflection point. Sentiment on the dollar is very bearish, and its long-term outlook is not promising at all. But this could point to either another leg down (the beginning of a disorderly slide that many observers worry about) or could also produce a snapback rally if an unexpected rise led to short covering (particularly if equities markets rallies were to fade and lead investors to seek cover until the dust settled in Treasuries).

From Bloomberg:

Central banks flush with record reserves are increasingly snubbing dollars in favor of euros and yen, further pressuring the greenback after its biggest two- quarter rout in almost two decades.

Policy makers boosted foreign currency holdings by $413 billion last quarter, the most since at least 2003, to $7.3 trillion, according to data compiled by Bloomberg. Nations reporting currency breakdowns put 63 percent of the new cash into euros and yen in April, May and June, the latest Barclays Capital data show. That’s the highest percentage in any quarter with more than an $80 billion increase.

World leaders are acting on threats to dump the dollar while the Obama administration shows a willingness to tolerate a weaker currency in an effort to boost exports and the economy as long as it doesn’t drive away the nation’s creditors. The diversification signals that the currency won’t rebound anytime soon after losing 10.3 percent on a trade-weighted basis the past six months, the biggest drop since 1991.

“Global central banks are getting more serious about diversification, whereas in the past they used to just talk about it,” said Steven Englander, a former Federal Reserve researcher who is now the chief U.S. currency strategist at Barclays in New York. “It looks like they are really backing away from the dollar.”

The dollar’s 37 percent share of new reserves fell from about a 63 percent average since 1999.

Some believe that developing economies may be selling dollars:

Developing countries have likely sold about $30 billion for euros, yen and other currencies each month since March, according to strategists at Bank of America-Merrill Lynch.

That helped reduce the dollar’s weight at central banks that report currency holdings to 62.8 percent as of June 30, the lowest on record, the latest International Monetary Fund data show. The quarter’s 2.2 percentage point decline was the biggest since falling 2.5 percentage points to 69.1 percent in the period ended June 30, 2002.

But some think a reversal later is possible:

Central banks’ moves away from the dollar are a temporary trend that will reverse once the Fed starts raising interest rates from near zero, according to Christoph Kind, who helps manage $20 billion as head of asset allocation at Frankfurt Trust in Germany.

“The world is currently flush with the U.S. dollar, which is available at no cost,” Kind said. “If there’s a turnaround in U.S. monetary policy, there will be a change of perception about the dollar as a reserve currency. The diversification has more to do with reduction of concentration risks rather than a dim view of the U.S. or its currency.”

However, despite the noise from the hawks at the Fed, the official pronouncements have all indicated that the Fed expects to keep rates low for quite some time.

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4 comments

  1. Drew Birenbaum

    Hey Yves, I don’t comment all that often but when I see something that catches my eye, I’ll jump in. From a technical perspective, the Dollar is showing some major warning signs of another leg down (disorderly). On the flipside as you mentioned, a technical short-covering bounce wouldn’t be surprising either. I go more in-depth on this in Monday’s market analysis http://bit.ly/f6i0r

  2. Robert

    Woah

    1. A single foreign central bank can sell assets to another entity, but the foreign sector as a whole cannot decrease its dollar holdings. Only if they sell dollar assets, on a net basis, to the U.S. can foreign holdings of dollar assets decrease.

    2. To sell net assets to the U.S. is equivalent to the U.S. running a current account surplus.

    3. In general, the growth of the foreign sector’s holdings of dollar assets over a period is exactly equal to the current account deficit for that period.

    4. The current account deficit shrank during this crisis, which means, by identity, that foreign holdings of dollar assets also shrank.

    The only “choice” that the foreign sector has is to decrease its current account surplus with the U.S. that is the only way to dump dollar assets or diversify out of dollars.

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