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Are we reaching the end of an era for US dollar strength?

Analysts have been predicting the demise of the dollar for a long time. There are good reasons for doing so. Frequently the dollar looks expensive on traditional measures like purchasing power parity. The United States runs twin deficits, both fiscal and current account, and that’s at least theoretically associated with currency weakness. 

Against that, the US continues to benefit from so-called “Exorbitant Privilege” (the term is attributed to a French finance minister) – that the US can run these deficits by virtue of having the dollar as the world’s reserve currency – in which many commodities are priced. And you could argue that the dollar has already weakened. The broad dollar currency index (DXY) is back to where it was in around 2015/2016 from its peak in mid-2022.

It’s also worth remembering the obvious point that currencies are relative prices. US debt to GDP may be high versus history, but it’s not really higher than the debt to GDP of Italy or France (Germany does rather better on this metric). And the UK is catching up quite fast. Similarly, we may see the US Federal Reserve cut rates in 2024 earlier than other Central Banks, but that reflects relatively lower US inflation. If we look at a simple measure of real interest rates (10-year yields less current 12-month CPI), US real rates are currently well above the UK or Germany.

As for the dollars privileged position in the financial system, there are reasons to question if that can continue. The rise of China suggests we may be moving towards a more multi-polar world. China and other trade partners are looking to price some commodities in currencies other than the US dollar. But Chinese financial markets are not yet as freely accessible as those in the US and Europe. Similar arguments were also made around the time of the Euros launch. US politics also looks quite dysfunctional at present – and that could have an impact on the outlook for US assets going forward (it probably hasn’t so far). But political stability is in short supply outside the US as well. 

We’d argue that the dollar is likely to remain the pre-eminent currency for some time to come even if other currencies like the euro and the yuan are likely to become increasingly relevant for global trade.

“Questioning the dollar’s validity as reserve currency isn’t something new – during multiple periods of stagflation throughout history, the dollar continued to hold relevance. Countries around the world hold US treasury bonds and peg their currencies to the dollar for stability. This also includes China, which moved to a ‘managed float’ system against a basket of currencies, yet it values the Yuan against the dollar to benefit its export-driven economy. 

 The softening monetary policy in the US should not destabilise the safe haven status – contextually, there is an inflation differential between countries. Despite widening trade deficit, the US is the largest global economy in the world for now with a GDP of 26.8 trillion. Countries around the world continue to count the US as their largest trading partner, and thereby validates the need for the US dollar. 

The sanctions on Russia necessitated the need to sidestep the US dollar, particularly by importers of Russian commodities. India, which is a heavy importer of Russian crude, has explored payment options including with the UAE Dirham and the Rouble.        

Similarly, China, which is in the crosshairs with the US on areas including semiconductor trade, is conscious of any escalations impacting its economy. For this reason, China has been dumping US treasury bonds, and currently holds about $870 billion in US debt – the lowest amount since 2010. The country is now actively negotiating agreements with other countries for a Yuan denominated trade.    

Despite the emergence of these small currency blocks, apart from the Yuan, there are no stable currencies capable on servicing international trade. Going back to the example of Russian crude, Russia has refused to trade with the Indian rupee considering the volatility and trade deficit. Against the Yuan, the Dollar offers credibility through a free exchange mechanism. You can be sure, with a high degree of certainty, that the Fed will not fix the rates. This is the reason why 58% of the world’s forex reserves are in dollar as opposed to 2.7% in Yuan.”

Richard Flax: Richard is the Chief Investment Officer at Moneyfarm. He joined the company in 2016. He is responsible for all aspects of portfolio management and portfolio construction. Prior to joining Moneyfarm, Richard worked in London as an equity analyst and portfolio manager at PIMCO and Goldman Sachs Asset Management, and as a fixed income analyst at Fleming Asset Management. Richard began his career in finance in the mid-1990s in the global economics team at Morgan Stanley in New York. He has a BA from Cambridge University in History, an MA from Johns Hopkins University in International Relations and Economics, and an MBA from Columbia University Graduate School of Business. He is a CFA charterholder.

 

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Written by Richard Flax

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Richard is the Chief Investment Officer at Moneyfarm. He joined the company in 2016. He is responsible for all aspects of portfolio management and portfolio construction. Prior to joining Moneyfarm, Richard worked in London as an equity analyst and portfolio manager at PIMCO and Goldman Sachs Asset Management, and as a fixed income analyst at Fleming Asset Management. Richard began his career in finance in the mid-1990s in the global economics team at Morgan Stanley in New York. He has a BA from Cambridge University in History, an MA from Johns Hopkins University in International Relations and Economics, and an MBA from Columbia University Graduate School of Business. He is a CFA charterholder.

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