When the US dollar weakens against other major currencies, commodity prices tend to go up in price. This phenomenon is called a cycle and is caused by the petrodollar system. The most traded commodity in the world is oil and most oil transactions are denominated in US dollar. Besides crude price, the other two indicators of macroeconomic forces on the US dollar is the USD-YEN currency pair and gold. Gold prices have been dropping from its highs in August of 2020.
Economic cycles are caused by the dominance of the US dollar and its use as the reserve currency. The liquidity of US dollar makes it the preferred currency choice in international markets due to its ubiquity. International banks typically conduct cross border lending or trade credits using the US dollar as a denominator. This process indirectly creates a demand for US dollars. Unlike Primary Dealer Banks or the US Congress, international players are not able to create US dollars, it can create demand but not the supply.
US dollar liquidity is provided in the international markets through a couple of methods:
- currency swaps between federal reserve and international central banks
- US treasuries notes, bills, and bonds
- US International Foreign Aid
- US primary dealers and US Federally Chartered Banks
The US dollar major index (ticker: DXY) benchmark is pointing to a rising dollar. It is important to understand that most borrowings around the world are dollar denominated debt. As many countries are facing pressures due to COVID19 at home, their need to borrow funds to fund fiscal deficits are rising. Businesses all around the globe that trade in dollars are now pressured to pay their dollar denominated debts are locking in sales or refinancing in order to raise cash to manage their debt burden.
In order to understand what might further cause a liquidity crisis, we can use a recent example where a Pakistan Airline plane was repossessed because it defaulted on a 14 million dollar lease. Due to the pandemic, the entire airline industry is facing a massive cash crunch. Most planes are either made by Airbus or Boeing and has some sort of financing arrangement denominated in US dollar. US Airlines are well positioned due to bailout funds approved by the US Congress. International players on the other hand are actively raising funds in order to meet their debt obligations. Now consider the same issue playing out across multiple industries including tourism, hotels, and cruise ships.
A US dollar liquidity crisis can happen when supply of US dollars are squeezed due to a couple of factors:
- US Consumers are cutting spending
- US primary dealers and Federally Chartered Banks stop lending due to default risk
- High demand of US dollars among emerging market economies
There is also the risk of the repo market or repurchase market freezing due to liquidity issues but due to the Federal Reserve’s backstop, that risk is low compared to an insolvency crisis. The repo market is a short term lending instrument used by financial players to meet their short term liquidity needs and its risk to the system is explained here in the “Great Dollar Crisis“. Further risk lies in equity markets where the lost in value of equities could cause a supply shock leading to mass liquidation into the US dollar. Up to date the US national debt is around 27.8 Trillion dollars and it is projected that the amount of US dollar denominated debt is 30% above that amount. If a significant amount of US dollar denominated debt starts to default, it could cause banks to freeze lending leading to another major liquidity crisis similar to March 2020.