One of the major explanations for the dollar’s continuing outperformance vis-a-vis other major currencies is simply that the pool of high quality assets around the world is shrinking. The latter is especially the case in Europe, where only Germany, the Netherlands, Luxembourg and the Scandi countries enjoy the highest long-term foreign currency debt rating from the three major rating agencies. Only a handful of countries are in a position where the CDS on their debt trades under 100bp, with the United States being one of those. As such, for those real money managers who are constrained by their investment mandates to only invest in the highest-rated assets, the options beyond dollar-based assets are becoming increasingly limited. Indeed, the US accounts for three-quarters of the USD 14 trln of sovereign debt where 5yr CDS are trading beneath 100bp.
Increasingly evident is that some sovereign wealth funds are reducing their euro exposure in favour of other reserve currencies such as the dollar, but also sterling and the Japanese yen. The former are conscious that a much lower proportion of eurozone sovereign debt securities meet their investment criteria, and as a result they are naturally inclined to reduce their currency exposure at the same time. Also, central banks in other safe haven countries such as Japan and Switzerland have been fighting a very determined rearguard action against local currency strength, diminishing the foreign appetite for their securities and currencies. In contrast, the Fed is completely relaxed by the gains in the currency, and the increased demand for treasuries being exhibited by foreign investors.
This theme could continue to run in the dollar’s favour for a time, despite the fact that the single currency is incredibly oversold.