The Dollar Has Peaked: Update And Broad Market Implications

Summary

• The dollar could be losing its reserve currency status
• This could lead to higher US interests and less ability for the US to run chronic trade deficits
• There could also be greater scope for competitive devaluations

Market implications

• The trade-weighted dollar should weaken
• Precious metals like gold could appreciate significantly.
  
  

In early April this year I wrote a two-part series forecasting a major correction in the dollar of 10% or more in broad, trade-weighted terms. The dollar did indeed decline somewhat in the subsequent weeks (Chart 1). Recently, it has staged a modest recovery. But in my opinion, there is much more potential downside ahead, primarily for fundamental, structural reasons rather than mere cyclical factors.

This past Monday, prominent dollar ‘permabear’ Stephen Roach published a piece in the Financial Times, ‘The End of the Dollar’s Exorbitant Privilege’. In it, he argues similarly to me in my April series, and as he himself has written before. Roach highlighted what he terms the ‘lethal interplay’ between a chronically low US domestic savings rate and, long before Covid-19 came along, a comparably chronic trade- and current-account deficit.

To a very real extent, these factors are two sides of the same coin. But in his recent piece Roach goes one important step further by identifying their common root cause: the ‘exorbitant privilege’ the US enjoys as the issuer of the world’s dominant reserve currency. He then claims, somewhat ominously, that the US is about to lose this privilege and that, as a result, the dollar is likely to decline by over 30%.

While that may sound like a rather bold claim, a 30% decline in the broad, trade-weighted dollar is roughly what is required to restore US competitiveness in global export markets. Such an adjustment could take place domestically. That is, real effective wages could decline by some 30% and/or the US domestic savings rate could shift sharply higher for some exogenous reason. However, given that these structural imbalances have been growing, cycle after cycle, for roughly half a century, it is hard to imagine why they would suddenly reverse, absent a shock or crisis of some kind.

America’s Bipartisan Addiction to Deficits

Modest cyclical swings aside, US households generally do not change their overall borrowing and spending habits. As for the public sector, if there is one thing that the Trump presidency and current re-election campaign have made clear, it is that the Republican Party is no longer the party of fiscal prudence, as it traditionally claimed to be. The Democratic Party, meanwhile, has been to a significant extent seduced by grand spending notions. These include a ‘Green New Deal’ or even a universal basic income programme funded through qualitatively higher government borrowing, perhaps financed along the lines of that which is advocated by adherents of Modern Monetary Theory (MMT).

Having critiqued MMT in a prior series for MacroHive, I will not rehash the case here. However, it is important to point out that even the most hard-core MMT advocates admit, when pressed, that MMT policies would fail to be effective or sustainable in the event that a) the country in question runs a chronic trade deficit, and b) the country’s trading partners refuse to hold the country’s currency of issue as reserves. As such, some MMT sympathisers readily admit that their policies, if taken to a logical extreme, would amount to a form of ‘monetary imperialismRoach’s focus on the dollar’s dominant reserve status is therefore well placed. He is right to point out just how this has been and remains key to the dollar’s lingering strength in context of chronically weak currency fundamentals since the 1990s (Chart 2). But while I agree with his reasoning, I don’t think Roach goes quite far enough in drawing the full set of implications of just what the dollar’s loss of reserve status would imply for the US and global economy.

The Profound Implications of Dollar Weakness

It is one thing for an ordinary currency to decline for ordinary reasons, say due to movements in real interest rate differentials, real effective exchange rates, or changes in fiscal policies which lower the domestic savings rate. It is quite another, however, for a currency to decline because of an exogenous shift in reserve demand.

In the former case, all that really happens is that relative prices adjust, thereby rebalancing imports and exports and placing the domestic economy, and that of its trading partners, on a more stable, sustainable path. Indeed, it is the expectation of these sorts of regular adjustments that led Milton Friedman and other monetarist economists to advocate free-floating exchange rates as the Bretton-Woods arrangements were breaking down in the early 1970s.

But what happens when, for whatever reason, there is a sudden, exogenous decline in reserve demand? While the scale can vary a great deal, in those cases where large cumulative imbalances have built up over time, a balance-of-payments crisis is the usual result. While in recent years we have come to associate such crises with emerging markets, one needs not travel too far back in time to see that several major European economies faced such a situation periodically in the 1980s and 1990s. Great Britain also teetered on the edge on multiple occasions in the late 1960s and 1970s. There is also the more recent example of ‘Black Wednesday’, when the pound lost some 20% of its value in a single day.

However, in none of the above cases was the crisis centred around the country that issued the world’s dominant reserve currency. The closest the US has ever come to such a crisis was probably in 1987, following the Louvre Accord. The dollar was trending sharply lower throughout that summer and, by the fall, was the weakest it had ever been since the end of Bretton Woods. Meanwhile, due to sharply rising inflationary pressures, the German Bundesbank indicated it was going to begin raising interest rates. Pressure grew on the US Fed to follow suit in order to support the dollar. Financial markets grew wary, and, anticipating sharply higher US rates, global stock markets crashed on 17 October – ‘Black Monday’ as it came to be known.

The global stock market crash of October 1987 was spectacular in both size and scope. Yet it is probably of a smaller order of magnitude than the adjustment in risk premia that would be required to price in a major rebalancing of the US and global economy sufficient to restore US competitiveness and, in turn, set up China, Germany and other large exporting nations to be the new sources of consumption-led growth. While such a rebalancing may be inevitable – I certainly agree that it is – it is hard to imagine that such major shifts could be accomplished absent a general global recession, as all the necessary adjustments, macro and micro, are made.

But this discussion begs yet another, arguably more difficult question to answer. Assuming that global trade remains elevated during such a rebalancing, as befitting a highly globalised, integrated world economy, what currency, if any, is likely to replace the dollar’s reserve role? After all, there will still be trade deficits and surpluses between trading partners, although perhaps no longer so large as that built up by the US over the past 40 years. In which currency, or currencies, will these balances be held?

Reserve Currency Multipolarity – A Monetarist’s Dream?

Several prominent economists have sought to answer this question, including Nobel laureate (and ‘father of the euro’) Robert Mundell, economic historian Barry Eichengreen, and the late Rudiger Dornbusch. While disagreeing on specifics, they lean towards a ‘multicurrency’ view, in which several prominent national currencies all compete with one another on a more-or-less equal footing. As relative interest rates (and expectations thereof) rise and fall, so will the respective demand for their currencies as reserves. Here, too, one can hear a faint echo of the original post-Bretton-Woods arguments that Friedman and other Chicago School monetarists put forward.

While it is impossible to divine the future, it seems entirely reasonable that major economies such as China, the euro area and Japan, and of course the US itself, would all find their currencies in demand as reserves. But assuming that all factors were equal, this would imply that the US would no longer enjoy the exclusive economic benefit of paying its trading partners a structurally low real interest rate on accumulated reserve balances.

About a decade ago, consulting firm McKinsey performed a study attempting to quantify just how large this benefit was and concluded that it amounted to roughly 0.5%. While that may not seem like much, it is substantial in the world of ‘risk-free’ government interest rates. And the knock-on effects of higher US government borrowing costs on the private sector would be a drag on the US potential growth rate, both outright and relative to the rest of the world.

The Risk of Competitive Devaluation

Another factor to consider, however, is to what extent countries would continue to seek to manage their currencies as part of their overall macroeconomic programmes. China has a well-deserved reputation for following an export-led growth policy during the past decades. But it is not hard to argue that the euro area and Japan would resist unwelcome currency strength were the dollar to decline by the full 30% or more anticipated by Roach, especially were this to occur over a short stretch of time. Indeed, one can draw a loose parallel with the 1920s and 30s, when nearly every country devalued at one point or another in a collectively futile effort to retain global export market share.

Intriguingly, this prolonged, competitive devaluation era only ended when the last bastion of relative currency strength, the US, devalued the dollar versus gold in 1934. US real wage growth outstripped Europe throughout the 1920s. By the early 1930s, the US was no longer anywhere near as competitive as it had been in global export markets – a contributing factor to the high rates of unemployment during the early years of the Great Depression.

Although the US did not face a balance of payments crisis at the time – it was still a large net exporter – it nevertheless faced a severe domestic banking crisis. Fearful that banks would continue to fail, US households had begun to redeem their banknotes for gold. This run on US banks’ gold stock would only stop following the election of FDR, who declared a bank holiday and made it illegal for US households to hoard monetary gold.

History only rhymes rather than repeats. Yet it is easy to imagine that, under a hypothetical future international monetary system in which multiple currencies circulate more or less equally as reserves, the perceived risk of currency management or possible competitive devaluation would be elevated, especially if this were accompanied by a general global economic deleveraging and possible recession. Investors seeking to hedge against these risks would naturally seek out the one monetary safe haven that cannot be arbitrarily managed or otherwise devalued: gold.

Any structural shift in favour of gold demand could have a disproportionate impact on price because the supply of gold is essentially fixed. I explored this possibility in my gold series earlier this year. Depending on how one goes about modelling gold supply and demand, a case can be made that the price of gold would need to be an order of magnitude higher to clear the market in a world in which currency risks were perceived to lie structurally higher than under the long, ‘Pax-Americana’ dollar-centric reserve system that has existed since the early 1970s.

A Silver Lining?

While other monetary alternatives might also re-rate higher in such an environment, I do not believe that bitcoin, or any other cryptocurrency, is well enough established to function as a true safe haven for monetary demand. Indeed, I would argue that other forms of liquid real assets, including certain other commodities, are more likely to re-rate higher along with gold. Therefore, a case can be made that metals generally would outperform. Silver in particular, still looking very cheap versus other precious metals in a historical comparison, and possessing anti-microbial and photovoltaic properties particularly attractive for a post-Covid ‘Green/EV’ world, has much room to outperform in this regard. And I would expect to see the gold/silver ratio decline to at least 60 over the coming year. That still lies well above the long-term historical ratio of under 20. But in order to see silver re-rate by that order of magnitude, it would probably need to be re-introduced as actual circulating coinage, a highly speculative view, even coming from me.