The USD’s Last Dance
Why the Dollar Could Surge Despite “Weak” Fundamentals
A Paradox of Weak Fundamentals and a Strong Dollar
Conventional wisdom suggests that a currency should fall when its home country’s fundamentals deteriorate. By that logic, the U.S. dollar might seem ripe for weakness: the United States faces large fiscal deficits and even endured a credit rating downgrade in 2023 due to debt concerns[1][2]. On top of that, there’s loud talk of “de-dollarization” – countries seeking to reduce reliance on the dollar for trade and reserves. Such headlines paint a narrative of a declining dollar. And yet, the reality is more complex. In practice, the dollar remains the indispensable currency of the global financial system. It still dominates international trade, finance, and central bank reserves, far beyond America’s share of the world economy. For instance, over 80% of global trade finance is conducted in dollars, and nearly 60% of official FX reserves are held in dollars[3]. In other words, even as some diversify at the margins, the dollar’s grip on global commerce and finance is unparalleled. This discrepancy between narrative and reality hints at a paradox: even with “weak” U.S. fundamentals, powerful forces can drive the dollar higher. In fact, those very forces are baked into the structure of the international monetary system. When stresses emerge, the world’s need for dollars can overshadow concerns about U.S. deficits or geopolitics, fueling a dollar rally when many expect decline. The stage is set for what we might call the dollar’s “last dance” – a final surge in value, even as longer-term trends suggest an eventual denouement.
The Global Dollar System: Debt, Banking, and the “Shadow” Dollar
To understand why the dollar can spike even amid bearish sentiment, we must examine the mechanics of the global dollar system. Over decades, businesses, banks, and governments worldwide have accumulated massive dollar-denominated debts and liabilities. By end-2024, non-U.S. borrowers (outside the United States) owed about $13.2 trillion in U.S. dollar credit (loans and international bonds)[4]. This includes emerging-market corporations that issue dollar bonds, households taking dollar loans, and others who find dollar funding attractive (often because interest rates are lower than in local currency). Crucially, many of these borrowers earn revenue in their home currencies, not in USD. They effectively short the dollar by borrowing in it – if the dollar strengthens, their debt burden grows in local-currency terms[5][6].
Beyond bonds and bank loans, a “shadow” dollar system amplifies this exposure. Banks and investors extensively use foreign exchange (FX) derivatives like swaps and forwards to obtain dollar funding off the balance sheet. The Bank for International Settlements (BIS) reports that by end-2023 dealer banks held a staggering $91 trillion in outstanding FX swaps/forwards involving the dollar[7]. These short-term instruments (often used to swap into dollars temporarily) don’t show up as debt in accounting statements, leading researchers to dub them “missing” dollar debt[8][9]. Estimates suggest that non-U.S. companies and other “customers” outside the U.S. owe roughly $28 trillion in such hidden dollar obligations – on top of their on-book dollar loans[10]. In fact, this off-book dollar debt is about double the size of their disclosed dollar debt[11]. Likewise, non-U.S. banks carry enormous dollar liabilities: by late 2023 they owed about $21 trillion on balance sheets – and roughly another $20–$25 trillion off balance sheet via FX swaps[12].
This entire edifice – dollar loans, bonds, and swaps spanning the globe – constitutes a dollar-based credit system largely outside U.S. borders. It’s facilitated by global banks that intermediate dollars worldwide. Notably, three-quarters of non-U.S. banks’ dollar liabilities are booked outside the United States (in London, Hong Kong, etc.), where they don’t have direct access to the Federal Reserve’s support[13]. These banks rely on private funding markets to roll over dollar loans and on their own internal capital flows to shuffle dollars to where they’re needed[13]. In calm times this works quietly. But it means that when dollar funding tightens, a large portion of the world’s dollar system is operating without an immediate Fed safety net – a dollar ecosystem in the shadows, vulnerable to stress.
In short, the world is leveraged to the dollar to an astonishing degree. Trillions in cross-border loans and “shadow” dollar bets have created an implicit short position on the U.S. currency across emerging markets and even advanced economies. Trade invoicing in dollars begets dollar debt that must be repaid[14], reinforcing the dollar’s central role. As long as this structure persists, global demand for USD isn’t just about trade flows or investor sentiment – it’s baked into balance sheets worldwide. And when those balance sheets come under strain, that demand can turn into a frenzy.
