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The “sell the dollar” trade is coming up in the chatter I see. I think that economists love making international trade and finance more complicated than they should be, but that is partly a side effect of needing to publish new articles on a continuous basis. My simplistic input on this topic is that people need to stop thinking about “global rebalancing” in terms of flows; price changes can do the job.

My guess is that the focus on flows draws from the experience of developing markets, with countries with less developed financial sectors. If a handful of rich people directly control most of the assets in a country, it is a lot easier to generate catastrophic herding behaviour. When financial assets are in the hands of professional investors, there is a more diffuse response, as many professional investors are liability matchers who have the capacity to go against the herd.

Price Changes Do the Job
 

Let us imagine that we are a foreign investor with a portfolio that has a weighting in US dollar (USD) assets of 30%. (Although foreign investors might have a higher weighting in US equities, fixed income assets have a home bias due to liability matching.) Let us further imagine that said foreign investors are spooked by the arbitrary legal manoeuvres of the White House, and want to reduce their USD weighting to 25%.

The hard way to do that is to do a portfolio analysis and move 5% of their portfolio out of the US

The easy way to do it is to wake up one morning and find that the local currency value of their USD portfolio has dropped by 22%. The value change can be accomplished by the dollar tanking or the assets falling in USD terms. Given the importance of equities in portfolios, generating valuation changes of that magnitude is not that hard. Besides the possible situation of Japanese investors, most foreign real money managers have relatively short-duration USD fixed-income assets. (The exception would be a portfolio that has no USD assets in its benchmark, and its USD exposure would only be relative value overlay trades, which could be long duration. This would not be surprising for Canadian fixed-income managers. However, risk budgets are finite, and the allocation to such overlay trades is going to have a small notional amount when compared to the portfolio size.)

Markets are like movie theatres. Fun to be in, at least until someone yells “Fire!” At which point, the exits are far too small for the number of patrons in the theatre.

USD Would Not Be “Replaced,” Just Shrunk (In The Short Run…)
 

There has long been a strand of analysis that went along the lines that the USD will not be replaced as the “global reserve currency” because other markets are “too small.” This analysis is arguably correct, but the point of failure is that “global reserve currency” is a very squishy qualitative concept. The weighting of USD in international transactions can be accomplished by shrinking the volume of international transactions and other currencies, just increasing their weighting at the expense of USD.

Unless one can find a country that has been running surpluses for some time (Australia was in that boat some time back), local fixed-income markets are going to be “big enough” for local investors. Sure, American investors might find investing in CAD bonds unattractive, but all that is needed that CAD investors do (and they are already major investors).

Japanese Investors?
 

The only fixed-income investors I see running for the door are Japanese investors who had large weightings in US fixed income because Japanese yields were structurally lower than US yields. The yield gap has been fixed, so there is an incentive to bring weightings home. At the same time, they realise that it is not in their interest to set their portfolios’ value on fire, so my default assumption is that any withdrawal would be relatively orderly.

Will There Be Massive Flows Out of the US?
 

Accounting tells us that about the only way to engineer large foreign outflows from the US is for the US to switch to a trade surplus. One of the structural problems of popular macro analysis is the inability to match buyers and sellers. People (including some academic economists…) seem to think about finance like their own personal portfolio, where they just hit “buy” and “sell” buttons.

An American trade deficit is the situation where Americans are net sellers of US dollars in exchange for goods and services. The only other part of international accounts big enough to absorb that dollar selling is the capital account — buying and selling the currency to buy/sell US and foreign currency financial assets. So, as long as there is a trade deficit in goods and services, there has to be a net inflow into USD assets.

We could see US investors repatriating foreign currency assets to cover the gap. I do not pay too much attention to international financial statistics, but US investors were historically notable for their home bias. It is unclear to me how large repatriation flows could be.

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