Waning Demand for US Dollar in $7.5 Trillion Market: Cross-Currency Basis Swaps Offer Insight into Shifting Capital Flows

The $7.5 trillion-a-day foreign-exchange market is witnessing a notable shift in demand for the US dollar, as indicated by recent changes in cross-currency basis swaps. This measure, which gauges the cost of exchanging one currency for another beyond what would normally be implied by borrowing costs in the cash markets, has captured the attention of Wall Street analysts.

According to experts at Morgan Stanley and Goldman Sachs Group Inc., the preference for the US dollar as measured by basis swaps has been relatively minor and short-lived, especially during market turbulence. Instead, demand for other currencies such as the euro and yen has grown, standing in stark contrast to previous scrambles for safety over the last two decades.

This shift in capital flows could ultimately make it more expensive to borrow the euro relative to the US dollar, presenting a challenge for the US currency at a time when its preeminent position in world finance is facing growing doubts. The Morgan Stanley team noted that the US tariff impact appeared to be "triggering a temporary withdrawal from dollar assets."

The cross-currency basis matters because it effectively sets the price of long-term foreign-exchange hedging for companies and investors worldwide. It's also an indication of the shifting trends in vast flows of assets between economies and asset classes. The Bloomberg Dollar Spot Index is down more than 8% this year, marking its worst start to a year since the gauge launched two decades ago.

Geopolitical risks still persist that show persisting demand for dollar assets in times of stress, such as when oil prices climbed following the Israeli and US strikes on Iran. However, Wall Street analysts are more focused on enduring shifts in global capital flows over a longer time horizon.

Guneet Dhingra, head of US interest-rate strategy at BNP Paribas SA, noted that there is definitely a fair bit of cross-border flow, particularly from the US to Europe. At Goldman Sachs, Simon Freycenet and Friedrich Schaper argued that the unwind of the European Central Bank's balance sheet will likely persist beyond the Federal Reserve's own quantitative tightening efforts. These dynamics should support the tightening of euro funding relative to the dollar over time.

In conclusion, the modest currency base moves in the wake of recent events are notable and likely reflect the absence of a dash for dollars amid a more resilient global financial system than before. Goldman ultimately sees potential for a continued shift away from the US dollar and towards other currencies in the coming years.