The US dollar remains unchallenged despite selling off during most of the COVID-19 pandemic. The Fed remains the most proactive central bank in the world, in charge of its reserve currency.
Much of a debate was triggered lately about the US dollar’s current position in the international financial system. Both fears of inflation and the race into cryptocurrency assets have led many to question the role of the dollar.
Wednesday’s inflation data spurred growing concerns that the price of goods and services may still rise, further depreciating the currency. While this is possible, it is not a certainty.
The market’s reaction says it all. The dollar rose on the inflation data as financial markets moved in a correlated manner.
The reason for this is whenever central banks intervene, as they did during the COVID-19 pandemic, the markets’ correlation intensifies. Risk-on and risk-off moves are the norm. As such, the rise in the dollar triggered by higher inflation may simply reflect the switch from a risk-on (long equities) to a risk-off (equities outflow) move.
The US dollar did rebound from an extreme level. The US dollar sentiment via hedge fund positioning revealed that USD capital outflows continued in April. As equities pushed to new all-time highs, the dollar’s decline looked natural.
US Dollar Still the Global Reserve Currency
Calls for the end of the financial system as we know it have been heard for decades. Ever since the United States dropped the Bretton Woods system at the start of the 1970s, the US dollar was “doomed.”
As it was no longer backed by gold, the logical conclusion was that nobody would want to own it. In fact, the opposite happened.
Fast forward a few decades to the 2008-2009 Great Financial Crisis, and the dollar was doomed again. How else to interpret the quantitative easing from the Fed, which at the time was something unseen in monetary policy before.
The same happened during the COVID-19 pandemic. Only this time, with the rise of cryptocurrencies, the dollar was dismissed even more vehemently.
Yet, the dollar is the currency that impacts global trade. It dominates worldwide capital flows, and its share as a global reserve currency remains unchallenged.
What traders and investors failed to anticipate was the Fed’s ability to adapt to severe economic constraints. We should all bear in mind that the Fed, and much of the world, faced two economic recessions in two decades, and the way out of each was to think one step ahead.
The unconventional measures (e.g., quantitative easing) used by the Fed in the aftermath of the Great Financial Crisis are widely used today and are part of the modern central banking toolkit.
There is a saying among traders and investors – “never underestimate the Fed.” We shouldn’t, as it has proven, time and time again, that it has the right medicine for each economic crisis.