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Yellen warns U.S. sanctions put dollar hegemony at risk as hedge funds turn positive on greenback

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(Kitco News) The theme of the dollar's dwindling power as a reserve currency is back in the headlines despite hedge funds turning more positive on the greenback, with U.S. Treasury Secretary Janet Yellen warning that the use of sanctions threatens the dollar's dominance.

Using sanctions against countries like Russia can put the U.S. dollar's hegemony at risk, Yellen told CNN.

"There is a risk when we use financial sanctions that are linked to the role of the dollar that over time it could undermine the hegemony of the dollar," Yellen said. "Of course, it does create a desire on the part of China, of Russia, of Iran to find an alternative."

And that's exactly what many countries have begun doing over the past year as they look for alternatives, especially when it comes to settling their trade transactions and diversifying international reserves.

Yellen added that it is difficult to find a good alternative to the greenback due to America's robust capital markets and the rule of law. "[These] are essential in a currency that is going to be used globally for transactions," she noted. "And we haven't seen any other country that has the basic... institutional infrastructure that would enable its currency to serve the world like this."

The U.S. Treasury Secretary did reiterate that sanctions remain an "extremely important tool," adding that "a coalition of partners acting together to impose these sanctions" works even better.

When responding to a question about the Russian reserves that were frozen, Yellen noted that "Russia should pay for the damages that it's caused" but pointed out that there are "legal constraints on what we can do with frozen Russian assets, and we're discussing with our partners what might lie in the future."

In the meantime, hedge funds finally turned optimistic on the U.S. dollar, betting that the greenback will reverse its longest stretch of weekly losses in almost three years. According to the CFTC data, for the first time since the start of 2020, leveraged funds were net short all major currencies against the U.S. dollar last week.

This coincided with some dollar strength triggered by expectations of another 25-basis-point Federal Reserve rate hike in May, which several U.S. central bank speakers confirmed over the past week.

"Shifting expectations around future Fed policy tightening continue to heavily influence the dollar," said FXTM senior research analyst Lukman Otunuga. "Expectations for a 25-basis point rate rise in May have risen to 86%, but the greenback has weakened against most G10 currencies this month with Fed official's speeches and key U.S. economic data this week impacting its short to medium-term outlook."

Richmond Fed President Thomas Barkin said Monday that more evidence was needed to confirm that inflation was easing back to the Fed's goal of 2%.

"This 'Fedspeak' will be the main focus for markets, although it may be wise to also keep an eye on the U.S. weekly initial jobless claims on Thursday and US PMI figures for April which are released on Friday," Otunuga said Tuesday.

The U.S. dollar index was last at 101.72, down 0.38% on the day. "Sustained weakness below 102.00 could result in a selloff back towards 100.79 and 100.00, a level not seen since April 2022," Otunuga added.

Fitch Solutions recently said that the greenback's role as a reserve currency will decline, describing the process as a "slow erosion" and not a "paradigm shift."

"We're gonna see that dollar dominance erode over time. That's because China is the largest trade partner of most economies, and as its economic might continues to rise, that means that it'll exert more influence in global financial institutions and trade, etc," Cedric Chehab, global head of country risk at Fitch Solution told CNBC this week.

Nobel economist Paul Krugman also weighed in on the topic in the New York Times op-ed last week, stating that the warnings of the U.S. dollar's collapse are exaggerated, but the risk of a U.S. debt default remains a big unknown.

"The dollar's role looks pretty secure — with one major caveat. I have no idea what will happen if, as seems all too possible, we end up defaulting on debt payments because a Republican House refuses to raise the debt ceiling. But it's not likely to be good," Krugman wrote.

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