Most of the world’s major currencies have declined in value relative to the dollar this year. The simple explanation for why: As the U.S. Federal Reserve has kept interest rates high in the face of stubborn inflation, the resulting higher yields on bonds and other assets attract international investors, strengthening the dollar’s position.
At this point, the dollar’s persistent strength has raised concerns that it may be poised for a fall after a 16-year run since the global financial crisis. Dollar doubters point to indicators that could erode its long-held role as the world’s currency of choice, including rising commodity prices, which are negatively correlated to the dollar; growing signs that Japan’s central bank will let interest rates rise, strengthening the yen against the dollar; a decline in dollar trades resulting from Russia sanctions and U.S. and China tensions; and increasing U.S. debt relative to gross domestic product (GDP).
But Morgan Stanley Research thinks the consensus on the dollar has gotten too pessimistic.
“Predictions of the dollar’s demise may be greatly exaggerated,” says James Lord, Morgan Stanley’s Head of Foreign Exchange Strategy for Emerging Markets. “It has the potential for cyclical decline if and when the Fed cuts interest rates but will still be bolstered by its enduring dominance as a reserve currency. It’s still the favored choice for central bank allocations, global trade financing, foreign exchange activity, cross-border lending and debt issuances.” Here are some of the factors supporting continued dollar dominance.
No Clear Challenger
Historically, for a leading global currency to be put aside, another one must be ready to step in, as when the dollar replaced the British pound after World War I. At this point, however, no clear challenger has emerged to replace the dollar.
“While the yuan is often seen as a growing challenger to the dollar because of China’s increasing economic and financial influence in the global economy, its role in global reserves and trade will rise about 2.3% by 2030 — not enough to threaten the dollar’s dominance, at least for the remainder of the decade,” says Lord.
Any challenges to the dollar will build slowly. China’s efforts to increase trade and investment, for example, are focused on countries that are geopolitically aligned, which could encourage more international use for the yuan. As much as one-third of China’s trade in goods could be invoiced in yuan by the end of the decade. But China also faces the “3-D challenge” of debt, deflation and demographics that could curb demand and slow this internationalization process.
Dollar Dominates Global Deals
One of the most important factors in assessing the dollar’s dominance is its role in cross-border lending. During the past 25 years, about half of all transactions globally have consistently been tied to the dollar. Significantly, about half of those dollar-denominated cross-border loans didn’t involve any U.S. lenders or borrowers. No other currency comes close, with most remaining below 10% of the market.
“When looking at cross-border lending, it doesn’t seem as though any other currency will challenge for the top spot in the near future,” says David Adams, Morgan Stanley’s Head of G10 Foreign Exchange Strategy.
Commodity transactions also underscore the dollar’s reserve currency role. Dollar doubters have speculated that rising prices, U.S. sanctions and increasing non-dollar trades could begin shifting more commodity transactions away from the dollar. However, any such shift is likely to be gradual. Most commodities, including oil and gas trades, are still invoiced in dollars.
“At the margin, there could be some shifts as trade flows change and new markets emerge, but any changes in the dominant currency for commodity markets would happen only slowly,” says Morgan Stanley Commodities Strategist Martijn Rats.
Finally, corporate debt issuance remains dominated by the dollar as U.S. corporations show little concern about the dollar’s reserve currency status. In the past decade, the share of dollar-denominated foreign currency debt has held steady at 50% to 60% of the total global issuance.
While the dollar’s status may be secure in the short and medium term, it does face long-term risks that bear watching. Market confidence may erode if U.S. debt continues to rise without higher taxes, reduced spending or both. Lord says the U.S. still has a chance to stabilize its debt, but if it doesn’t do so by 2030, greater risks may emerge. However, while the outlook for U.S. debt is poor, it’s currently no worse than those of Japan or Europe.
“The dollar is unlikely to enter a bear market,” says Adams. “While we understand the concerns, we don’t believe they have much credibility. Hold onto your dollars.”
For deeper insights and analysis, ask your Morgan Stanley Representative or Financial Advisor for the full report, “King Dollar Lacks Challengers,” (April 18, 2024).
