Central Banks Retreat From U.S. Dollar

Central banks such as the Federal Reserve are the largest players in the foreign-exchange market.

Central banks such as the Federal Reserve are the largest players in the foreign-exchange market.

Photo: Ting Shen for the Wall Street Journal

Among those paring U.S. dollar holdings in recent months: central banks.

The dollar’s share of global reserves has decreased to its lowest level since 1995, according to International Monetary Fund figures on central banks’ foreign-exchange holdings released last week. The currency now stands at 59% of global reserves as of December 2020—a 1.5 percentage point decline over the quarter.

The WSJ Dollar Index slipped 0.1% Tuesday, headed for its fourth decline in five sessions. It has fallen around 8% from a year ago, after the pandemic fueled a rush into ultrasafe assets and the dollar surged against the euro and British pound.

Although the dollar has edged higher year-to-date, some on Wall Street expect factors including trade deficits and China’s expansion to weigh on the currency this year. Central banks are the largest players in the foreign-exchange market, overseeing nearly $12 trillion in reserves, so investors watch their holdings closely.

“Several structural trends skew the medium-term dollar outlook in a negative direction, including the widening U.S. trade deficit, China’s financial opening and the European Union’s efforts to create a common bond market for the region,” said

Zach Pandl,
head of foreign-exchange research at Goldman Sachs, which forecasts a slightly weaker dollar over the next 12 months.

The dollar’s depreciation has driven its slip as a share of reserves, along with an increase in central bank holdings of currencies including the euro and Japanese yen.

That marks a reversal after the dollar’s share of global reserves increased at the start of the pandemic. Demand for dollars was so acute in March 2020 that the Federal Reserve intervened to alleviate stresses in currency markets by launching a facility to facilitate short-term dollar lending from the U.S. to other central banks.

Mr. Pandl said a retreat from havens will likely drag on the currency as the global economy improves and short-term interest rates in the U.S. remain relatively low—making it appealing for investors to move capital overseas.

Other analysts said that strong U.S. growth and rising interest rates might support the dollar over the short term. The yield on the benchmark 10-year U.S. Treasury note traded Tuesday around 1.692%, up roughly 0.8 percentage point year-to-date.

Tai Wong,
head of base and precious metals derivatives trading at
Bank of Montreal,
said gains in the dollar this quarter would likely boost the currency’s share of central bank holdings when the IMF next releases its data for the first quarter of 2021.

“The share of dollars as a global reserve currency may improve over the coming quarters if the dollar stays strong, which it may considering the larger yield pickup you get for holding U.S. assets versus most European ones,” said Mr. Wong.

Write to Julia-Ambra Verlaine at Julia.Verlaine@wsj.com