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“It’s the economy, stupid.” And now, thanks to the Ukraine War and the long series of sanctions and embargoes imposed on Russia by the US and NATO, market players are betting that for the first time since the market madness during the financial crisis in 2009, inflation will rise faster in Europe than the United States.

The bet is, the higher inflation the lower the value of currencies. Thus, the dollar remains the choice of central banks as a reserve currency, according to a new survey by trade magazine, Central Banking, of officials responsible for managing the banks’ asset stockpiles.

Fifty-nine percent of respondents agreed that the dollar is the reserve currency of choice; the other 41 percent “strongly agreed.”

The poll contacted 82 reserve managers who handle 48 percent of the world’s central bank reserves, worth about $7.3 trillion.

More than half of central bank assets are held in dollar-denominated instruments, such as U.S. treasury securities and similar assets quickly convertible to cash, according to a recent study by the International Monetary Fund.

The dollar tends to outperform other currencies during periods of economic or geopolitical turmoil, the Financial Times noted.

The dollar remains the top choice despite recent predictions that it eventually may be replaced by other currencies, in particular China’s renminbi as that nation’s economy emerges as the world’s largest.

Speculation about a weakening dollar has intensified since the U.S. froze about $300 billion of Russia’s central bank assets, mostly dollars, after the Ukraine invasion.

Preference for the dollar is not about security alone, one survey respondent said, but also the buck “still has the biggest financial market, the most transparent regulation, and the longest tradition.”

Although the dollar remains the top pick, many central banks have recently increased their holdings of the euro, pound sterling, Swiss franc, and yen, as we reported in “Dollar Under Assault as World’s Reserve Currency” (1 Jun 2021).

Dollar Days

The dollar is gaining strength at the expense of other currencies because investors believe the U.S. Federal Reserve will raise interest rates more aggressively than will the central banks in other major economies.

On 29 April, the dollar reached multi-year highs against the British pound, euro, and yen.

The euro sank to $1.047 to the dollar on 28 April and climbed back to $1.05 on 2 May. The British pound closed out April at £1.26 to the buck, its lowest in almost two years. 

China’s wave of lockdowns and declining economic data has also pushed investors toward the dollar as the primary safe haven currency.

The buck’s rally lofted it to its highest value since 2017 against a collection of six other major world currencies.

The Wall Street Journal Dollar Index, which measures the dollar’s strength against 16 world currencies, shows the dollar has gained 7.1 percent this year through 29 April, outperforming bonds, equities, and gold, and reached an index rating of 104, its highest since 2002.

The dollar tends to do well during times of economic and geopolitical uncertainty. (See related story in this issue.)

Also, the U.S. Federal Reserve’s newly aggressive stance on interest rates is luring investors away from higher-risk, lower-return possibilities.

Meanwhile, the euro continued its slide.

The European Central Bank (ECB) has refused to budge interest rates from -0.50 percent, where they have remained for almost eight years.

The bank will deliberately be slower to raise interest rates than the U.S. Federal Reserve, ECB president Christine Lagarde said in a public statement late last month.

Europe is bracing for a major economic blow from the Ukraine war and rates will remain low to encourage economic activity, she said.

“We’re seeing a long-overdue capitulation from investors who had been reluctant” to back the dollar against the euro, Athanasios Vamvakidis, Bank of America’s chief foreign exchange strategist, told the FT.

Markets have begun to “price in” a rate boost by the ECB but expect the bank to lift rates cautiously in the face of external economic dangers such as the war and inflation, the FT said.

Still, the euro is up against the British pound, Japan’s yen, and the Swedish krona so far this year. 

On 29 April, the Bank of Japan said it would buy government bonds every day at an interest rate of 0.25 percent to ensure rates do not rise past that level.

The news sank the yen to 130 to the dollar, its lowest point since April 2002.

The Polish zloty lost 2 percent after Russia cut off natural gas deliveries to the country on 27 April. Hungary’s forint and the Czech koruna also have lost value.

TREND FORECAST: China’s deepening economic woes will delay its emergence as the world’s leading economy. 

Despite the U.S. $30 trillion debt load and its economy sinking into Dragflation, minus a wild card event, we forecast that while the dollar will weaken over time, considering the economic pain and inflation being inflicted throughout Europe, the dollar will remain the world’s reserve currency of choice for at least the next three years.

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