The dollar's position as a global reserve currency is melting away, and several factors seem to be contributing to this. One of these became known after Brazilian President Luiz Inácio Lula da Silva called on developing countries to replace the US dollar with their own currencies for international trade. During a visit to China, Lula called on the BRICS countries (Brazil, Russia, India, China and South Africa) to develop their own alternative currency for international settlements. Similar concerns have been voiced by the chief US congressional economist Jared Bernstein. This seems to have a reasonable explanation, as global foreign exchange reserves in the dollar have fallen from 63% to 58 % since 2008. What assets might be affected and what can we expect?
Brazil wants to join forces with china
The Brazilian president's statement seems to fit in with China's actions, which is also seeking to end the dollar's dominance on the international stage. China is currently one of Brazil's most important trading partners, with trade between the two countries worth USD 150.4 billion last year. Listening to the Brazilian President, it is worth remembering that it could be in his country's economic interest to become independent of the US currency due to its strong link to commodity prices, the value of which is calculated in dollar terms.
Source: CEIC data
The "dollar smile" theory
The 'dollar smile' theory is an economic concept that suggests that the value of the USD tends to form a letter shape. According to this theory, the value of the dollar is expected to strengthen during periods of US economic expansion and crisis, while it is weaker during periods of moderate growth.
Source: https://corporate.nordea.com/article/63638/global-the-dollar-smile-and-its-future
The 'dollar smile' theory refers to the USD exchange rate forming a U-shape (see chart). The theory posits that the value of the USD tends to rise during economic cycles and financial turmoil, such as recessions, financial crises and geopolitical tensions, as investors seek a safe haven for their assets.
On the other hand, during periods of strong US economic growth, the value of the US dollar tends to decline, which may be due to investors seeking higher returns on their investments in riskier, high-yielding currencies and assets. This is because a stronger economy usually means a more stable investment climate, which stimulates investors' willingness to take more risk in order to achieve higher returns.
Finally, during periods of moderate economic growth, the value of the dollar tends to rise with less intensity than in times of crisis, as investors are guided by the stability of the USD.
In the most general terms, the 'dollar smile' theory suggests that the value of the USD is stifflydependent on global economic conditions, and that investors would buy or sell the currency depending on their predictions of the current and future state of the global economy. Currently, the USD index is pointing to a weakening of the currency. This may be due to a slowdown in rapid post-pandemic economic growth relative to other economies, which seems to encourage foreign investors to invest in developing countries.
Source: Tradingview
A weakening dollar good for commodities?
Commodity prices and the value of the dollar are considered negatively correlated, meaning that an increase in the value of the dollar could lead to a decrease in commodity prices and vice versa. In fact, the norm correlation for the quotations of the main commodities with the dollar index is minus 0.13. The correlation could take values from minus 1 to 1, where these extreme values indicate a strong correlation. Nevertheless, a correlation of minus 0.13 indicates a low correlation. Interestingly, the dollar index seems to have the most impact on silver quotations, where the correlation was minus 0.37. Therefore, a potential weakening of the dollar may have the most positive impact on the price of silver, but should not have a significant impact on commodity quotations at the same time.
Source: Tradingview
Grzegorz Dróżdż, Market Analyst of Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis and opinions contained, referenced or provided herein are intended solely for informational and educational purposes. Personal opinion of the author does not represent and should not be constructed as a statement or an investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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