US Dollar

De-facto Currency

The Federal Reserve plays an outsize role in driving global economic expansion and contraction.
How the U.S. dollar emerged as a de-facto global currency.
Trade tensions, tariffs, and cracks in the dollar’s dominance and overall global liquidity.
Hedge portfolio risks with gold.

Global central bankers and other international policymakers convened at Jackson Hole, Wyoming in August 2019 and found themselves discussing a decades-old conundrum that has found new legs in the world economy: the increasing dominance of the U.S. dollar in global transactions. Mark Carney, the governor of the Bank of England, went so far as to revive an observation credited to President Nixon’s then-Treasury Chief, John Connally, who noted that the “dollar is our currency, but your problem.” Carney went so far as to suggest a global digital currency that relies on new technologies and that could be controlled by public authorities.

Almost fifty years ago, the United States abandoned the post-World War II Bretton Woods standards and decoupled the dollar from gold, setting the stage for expansion not just of U.S. industry and trade but also for the economies of countries around the globe. Those countries implicitly, and in some instances explicitly adopted the dollar as a universal standard of value.  Without the constraints of a gold standard, the U.S. Federal Reserve pumped trillions of dollars into the national and global economies. This had a natural inflationary effect, but it also spurred new opportunities and a massive expansion in global trade.

The expansions and contractions that have elapsed without the discipline of a gold standard have given economists and policymakers new insights into cycles of global liquidity and leveraging, and the conclusions are not necessarily all good news. The dollar’s dominance in global trade means that every time any internal or external threats arise to dollar supply and liquidity, the global economy will tighten very quickly. The trade and tariff rhetoric between China and the United States is evidence of this. Investors with short-term investment strategies and plans are reacting to these downturns by shifting assets from dollar holdings and into gold.

Source: ZeroHedge

The Federal Reserve can seemingly dictate expansion or contraction

When countries ran their economies in lockstep with their gold reserves, currency deficits and surpluses had real and immediate ramifications on the ability of their industrial bases to compete in a global economy. With currencies and gold going their separate ways, those ramifications were no longer as significant a concern. Countries could boost currency liquidity with no constraints and enable their industries to participate in a global financialized economy.

As the U.S. dollar became the de facto default medium of exchange in this economy, Connally’s prediction that the dollar is “your problem” came to pass. The Federal Reserve can adjust dollar supply and liquidity to control a domestic economy, but the international economy can only expand when the Fed sees fit to expand the U.S. economy. Any liquidity reduction in the United States dollar creates an analogous reduction in the global economy.

It is no surprise, then, that investors are watching for any signs of weakness that might reveal contractions in the U.S. economy.  Consider, for example, the recent focus on the inverted yield curve, where interest rates on long-term Treasury bonds are falling below the rates on short-term bonds. Other signs of weakness that are scaring investors include reductions in manufacturing activity, lower corporate earnings after the 2018 U.S. tax cuts are fully accounted for, softer housing prices, and less consumer spending.

The high and mighty status of the US Dollar on the global stage

Contrarians emphasize reductions in the US dollar currency index and the emergence of other indicators, including the Chinese Renminbi as major global reserve currencies, to argue that the belief in the dollar’s predominance is overstated.

Source: New View Economics

The dollar’s share of global central bank reserves has certainly dropped from 73 per cent to 62 & in the last twenty years. Nonetheless, the Renminbi accounts for only 4% of global currency transactions. A study by the National Bureau of Economic Research revealed that in 2018, the proportion of global imports priced in U.S. dollars was 4.7 times the total of U.S. imports, and global exports were 3.1 times total U.S. exports. These proportions dwarf the second-place Euro, which accounts for 1.2 times global imports and exports. Global transactions can move away from the dollar for another twenty or more years, during which time the Fed will continue to have an outsized influence will on global economy.

Before 1971, countries pegged their economies and transactions to a neutral and agnostic gold standard that no one country controlled. The dollar’s emergence shattered that neutrality and elevated the Federal Reserve into the role of a universal worldwide central bank.

What trade wars mean for global liquidity and leveraging

When the Fed expands the money supply and overall liquidity, interest rates go down and consumers and businesses binge on cheap credit. Critics point out that the credit binge that began in 2008 and the resulting global economic expansion were built on a nonexistent foundation. Any attempt to shut down the availability of cheap credit will inevitably expose the weakness of that foundation. Signs of the first crack became apparent in late 2018, when the spread between corporate and Treasury bond yields began to grow.

Source: St. Louis Fed

Trade tensions and potential tariffs on Chinese goods are partly, if not wholly to blame on the first decline in Chinese auto sales in two decades. Germany reported its first sharp drop in industrial production since the global economic crisis of 2008-2009. It remains to be seen whether the Fed recent reduction in interest rates will offset the effects of trade wars.

That offset, however, can create a stronger dollar, which in turn will weaken other currencies and reduce global trade and liquidity. This runs counter to the attempts by the current administration to reduce current account deficits and to bring into balance the amount of goods that are imported into the United States with the amount exported. If U.S. current account deficits continue to drop, both industrialized countries and emerging economies will experience a reduction in global liquidity. Whether the situation would be the same if the U.S. dollar were not the de facto global currency is an academic question.

The greater question is what can an investor do to gain insulation from these conditions. This question has no simple answer, but investors can derive some direction if trade tensions continue and global liquidity continues to fall.

Trade tensions and tariffs can drive global transactions into currencies other than the U.S. dollar. Smart investors will watch the trends in the percentage of global currency reserves that are designated in U.S. dollars. If China and the United States are unable to resolve their trade and tariff disputes, those trends will likely continue to be on a downward slope.

If other countries experience further reductions in industrial activity, investors would be well served to hedge their risks in at least a portion of their portfolios.  Advisors have long recommended that investors hold between 1% and 5% of their total portfolios in gold. It may well be time to increase those percentages.