Watch out for dollar FX fall more than 'de-dollarization'

Reuters

12-06-2025

LONDON, June 12 (Reuters) - Evidence of "de-dollarization" around the world remains scant, but many major investors fear a gradual drawback from U.S. assets is now inevitable and the dollar's exchange rate may have to fall further to clear the market.
The debate about the U.S. dollar's dominant role in global trade, reserves and investment portfolios has smoldered for decades, but it has reached a crescendo during the turbulent first few months of President Donald Trump's second term in the White House.
European Central Bank boss Christine Lagarde, opens new tab recently put a spotlight on this shift in market thinking, noting "highly unusual cross-asset correlations" involving simultaneous drops in the dollar, Treasuries and U.S. stocks after Trump's import tariffs announcement in April.
But despite all of the de-dollarization noise, there are still no clear indications of a mass withdrawal from dollar assets at large.
In fact, some investors dismiss these fears altogether given the pattern of the past 10 years.
Bank of America strategist Ralph Axel argues that despite all of the speculation, the world has actually been "rapidly dollarizing" over the past decade - at least in the sense that dollar liabilities have expanded enormously.
In a research report on Thursday, Axel points in particular to the growth of the so-called shadow banking system, otherwise known as "Non-Bank Financial Intermediation", or NBFI, and refers to the universe of investment funds, private credit firms and even crypto funds that exist outside the regulated banking system.
All dollar liabilities are effectively "money" in the sense that they can be sold for dollar cash and are thus ultimately claims on the Federal Reserve. Some of these liabilities are direct claims, such as U.S. Treasuries, but there are a blizzard of indirect claims through uninsured deposits, mortgage and corporate debt and investment fund shares.
Dollar liabilities have clearly ballooned in the past decade. The U.S. federal debt has increased four-fold in less than 10 years to some $36 trillion, while bank deposits have more than doubled to $18 trillion since 2008.
And, as Axel points out, the total size of "shadow banks" has also more than doubled since 2009 to roughly $63 trillion, according to S&P Global data. While much of this expansion simply reflects asset price appreciation, Axel notes that "the NBFI system can only grow because of demand for its liabilities."
The point of all this number-crunching is to undermine the simplistic de-dollarization narrative. If de-dollarization were truly accelerating then fewer, not more, U.S. liabilities could be created, whether from the government, traditional lenders or shadow banks. And the trend has clearly been the other way.
"A big selling wave can move prices and exchange rates temporarily but does not de-dollarize," he wrote. "As a result, we think the de-dollarization theme is less threatening, especially given what appears to be a stronger trend of global dollarization over time."
In other words, the exchange rate of the dollar can fall even if dollar assets are not contracting. A weakening exchange rate simply signals that temporary demand for dollar assets is declining and a lower dollar sticker price is needed to clear the market.
"We would caution investors to not miss the dollar story for the dollar trees," the Bank of America strategist concluded, in reference to the confusion between exchange rates and the ubiquity of dollars and dollar assets.
Of course, the trends of the last 10 to 15 years may have crested, and that's precisely this year's concern.
Questions about the dollar exchange exposure were also raised by Deutsche Bank's currency research team this week in a deep dive into the hedging behavior of the world's big pension and insurance funds with the heaviest overseas assets holdings.
They showed that Nordic, Dutch and Australian institutional funds had more than 50% of their investment portfolios invested abroad, with Japan's and Switzerland's foreign holdings also high at above 30%.
They concluded that most of these investments are in the U.S. and much of the currency risk is not being hedged, meaning exposure to the U.S. dollar is likely historically high.
But as these funds' hedging activity is now increasing, they reckon, it should pressure the dollar exchange rate lower.
All of which raises an important, albeit circular, question.
To what extent was the performance of U.S. assets exaggerated in recent years by investors assumption of an ever-rising dollar and a hedge against global shocks? And was the dollar just rising because of that outsize overseas demand for U.S. stocks and bonds?
And, on the flip side, to what extent could a weakening dollar now cause demand for those assets to fall?
What market pricing near mid-year suggests is that even if de-dollarization fears are overblown, the dollar's exchange rate may be a necessary safety valve.
The opinions expressed here are those of the author, a columnist for Reuters.