Dominant Currencies Through History: Why USD is at Risk as a Reserve Currency and What Would Replace It

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As if we needed a friendly reminder, history tells us every dominant global currency shines brightly under the international spotlight… until it doesn’t.

The greenback has maintained its status as global reserve currency since shortly after the Second World War. It has limped through US President Nixon’s termination of gold convertibility in 1971, a historic global financial crisis emanating from the US, several asset bubble busts, and a prolonged 8+ year stretch of zero interest rate policy (ZIRP) paired with accelerated new money supply by the Federal Reserve’s QE programs.

Strategic political alliances with questionable partners at times and tragic international conflicts likely played a role in every empire maintaining dominance of its currency in global trade. This is nothing new, unique, nor surprising if viewed from a historical perspective.

Empires have gone to the greatest lengths possible, by any means necessary, to ensure global trade is conducted with their currency of choice. That is because the wealth of their citizens, businesses, and governments have depended on it.

Global demand for one’s currency ensures superior financing terms to invest in the things that increase living standards and real wealth. It also insures value preservation of a nation’s (or currency union’s) savings. With reserve currency status comes immense privilege and more room for error than enjoyed by those without it.

More room for error does not mean infinite room for error. Unfortunately, squandering wealth and credibility are much easier and faster to execute than building them. Human nature is highly cyclical and dynamic. Once an empire goes through the exhausting process of winning the hard way, it wants to enjoy the fruits of its labor the easy way.

Complacency sets in. Greed, impatience, and hubris replace the blood, sweat, and tears on which the empire was built. Short cuts become misinterpreted by common wisdom as “the new way to work smarter, not harder.” Mal-investment on unproductive activities are implemented to improve short term optics at the expense of long term real gains. Power breeds corruption. Corruption deteriorates trust in the social contract gluing a society together. The political power cycle peaks and begins to reverse.

The basis of Keynesian economics and “stimulating demand” now by stealing it from the future is inherently a product of short-cut thinking exhibited by an empire’s coddled intellectuals with no skin in the game. Why ever make difficult political decisions to prioritize finite resources or tighten one’s own belt when you can simply goose the economy for awhile longer with borrowed funds or freshly printed money?

Like the academics of previous eras, the academics of the current one have decided they have a short-cut with groundbreaking, new ideas: create new money from thin air and buy most of the bonds responsible for setting interest rates to keep rates low. Ah ha! Why hasn’t anybody else been so clever?

Of course, there is nothing groundbreaking whatsoever about demand-driven Keynesian economics. Different tactics, same tricks. There are no free lunches in economics over the long run. Eventually the long run becomes today.

Today’s central bankers and politicians have decided they are intelligent enough to increasingly control market economies better than all of those who have failed before them trying to do the same, and certainly better than a large number of diverse market participants with skin in the game from various perspectives competing for the best deals (aka, “markets”). The more things change, the more they stay the same.

Too much market intervention by central planners has some of the nastiest long term side effects imaginable, even with relatively good intentions in the short run. Unexpected losses in purchasing power, real wealth, and real wages have silently been responsible for contributing to wars and other bloody conflicts (ie. hyperinflation in Germany in the 1920s, 2011’s Arab Spring, today’s Venezuela) with fewer mentions than deserved. Nothing evaporates complacency and fuels anger like losing everything almost overnight.

When a debt situation deteriorates past the point of no return to a level of de facto insolvency, governments choose creating money from thin air to pay the bills 99% of the time rather than not paying them when presented with one or the other as the unfortunate final options on the table. This eventually, if not immediately, causes said money to lose its value.

In fact, even though the dollar is still the most widely held global reserve currency, it has lost approximately 95% of its purchasing power since the Federal Reserve was created in 1913 to manage the nation’s money supply. Throughout most of this time, the deterioration in value has been manageable because interest rates were high enough to compensate savers.

Now we have a policy of financial repression where savers are forced to lose real purchasing power on their savings without being compensated by adequate interest earnings. This has been a direct transfer of wealth from savers to debtors and government entities. That fact is yet to be fully appreciated by the public, broadly speaking.

When a currency rapidly loses purchasing power, faith and trust in its future value begin to erode even faster. Lenders of debt in said currency demand higher interest rates to compensate for the risk and expectations of additional losses in value.

High interest rates make it more costly for individuals to make large purchases or maintain their living standards in a cyclical economic downturn. High rates make it more difficult for new businesses to form and for existing businesses to expand. Most importantly, high rates make it terribly difficult for indebted governments to continue spending more than they collect in taxes, or even to pay back previous debts.

Yet, sometimes higher interest rates are exactly what is needed in order to ensure a moderately painful period of belt tightening rather than a full blown crisis or economic collapse down the road. This in return helps attract investment capital seeking higher rates of return to a struggling nation (or region) in need of it, thus creating demand for the beleaguered currency once again and completing the cycle.

This, anyways, is how it is supposed to work in a market-based economic system: self-correcting periods of relative economic strength and weakness with a bias toward long term wealth creation. This holds true even in hybrid economic systems where governments intervene to nudge economies in the direction of desired political outcomes without excessive force or explicit price controls.

But that is not the modus operandi in the current Keynesian global central banking regime. We have seen one experimental intervention policy after another enacted essentially in coordination by advanced economy central banks in order to keep the economic flame flickering and avoid another global recession. Economic nature has not been allowed to run its course with natural corrections in recent years, with few exceptions.

Equity volatility is at all-time lows. As in, forever. The Bank of Japan is buying stock ETFs at multi-year high prices, is forcing a negative interest rate at the short end of the debt curve, and is even manipulating the shape of the curve deeper out by instilling an unlimited bond buying program to keep 10 year JGB rates at precisely zero while there is no apparent recession to fight. The European Central bank is printing 60 billion euros per month and spending some of the money on bonds that have negative yields.

One would naturally wonder why central bankers have spent so much precious monetary ammo and political capital fighting the natural business cycle during a period of time in which the economic indicators are looking quite strong overall? They have explicitly pledged to do “whatever it takes” on a number of occasions to prop up the banking system and keep interest rates ultra low long past a time of actual crisis.

The answer is frightening: there is way too much global debt without the growth to support it and another major recession in several advanced economies could expose an insolvent global monetary system. What would happen if in a recession the US returned to $1-2 trillion dollar deficits with no end in sight and debt-to-GDP already stretched near maximum sustainable levels? If the deficit already looks increasingly bloated during a time of quasi full employment, and political dysfunction is preventing anything sensible from correcting course on the ship before it is too late, what does “too late” look like?

The Keynesian groundwork has been laid in the public discourse already. There will almost certainly be so-called “helicopter money” policies enacted by emergency decree during the next recession–direct coordination between the government and the Fed to monetize debt with no questions whatsoever about what is going on.

The Fed will create money to purchase not only financial assets, but will back the US Treasury with newly created money so it can cover its bills without technically “defaulting.” Financial repression will be relentlessly pursued to stop people from getting their money out of the banking system because private savings will be used to bail out unsustainable public debt one way or another. Either you spend it quickly to “stimulate demand” or watch it’s value diminish before your eyes.

If ever used, helicopter money will end USD’s reserve currency dominance reign.  It would no longer be trusted as a store of value, to the extent it even is now. The only way to effectively enact such heavy handed policies is through financial repression, limiting the use of cash, and quasi currency controls because otherwise there would be a massive run on the financial system. Everybody would try to get rid of their fiat currency deposits at the same time to instead acquire other assets that are superior stores of value.

Competing non-fiat assets would then be under the spotlight and removed as an option similar to how FDR made it illegal for private citizens to own gold in 1933 by executive order. People literally went to jail for owning gold. That type of policy would surely spark a much harsher public backlash this time around, resulting in at least a partial departure from the current USD dominated post-Bretton Woods monetary system.

The only way to prevent this from happening is for the US to ignite sustained GDP growth above 3% while gradually reducing debt-to-GDP over time.  Or, the government chambers could join together to enact unpopular budget cuts on things like entitlements and military spending, without diminishing tax revenues. Seeming how the same legislators have already made a mockery of the supposed hard cap budget sequestration enacted in 2013 by largely ignoring it, as well as publicly declaring that it will let its own healthcare system fail due to current political dysfunction,  the hill to climb seems steep for the greenback to remain the dominant reserve currency.

Contrary to the graphic at the top of this post, the Chinese yuan is not necessarily going to be a better alternative to the dollar. China’s debt problem might even be worse than the US’s. Traditional “paper” fiat currencies in general are highly subject to central bank oversupply and deteriorating faith in traditional institutions globally.

Digital blockchain assets such as bitcoin could be a viable alternative or complement to traditional fiat, at least eventually, but related businesses such as cryptocurrency exchanges could be targeted heavily in an intensified financial repression regime. It is still very easy to imagine demand for digital assets surging exponentially higher than supply with or without a helicopter money scenario taking place in the future.

The next official reserve currency is likely to be plural. SDRs, or Special Drawing Rights, are currency units composed of several major currencies that the International Monetary Fund (IMF) is increasingly highlighting as a better solution than USD for bank reserves. The problem with SDRs is that they are still based entirely on fiat currencies and are also centrally controlled, leaving them politically vulnerable and prone to perpetual devaluation.

The monetary system will become increasingly decentralized as a natural response to too much centralized planning reliance and risk concentration. SDR’s and even government sanctioned crypto assets will include USD in the global financial system, albeit with a diminished role from its current dominance in energy commerce and bank reserves.

On an individual level, diversification into prime real estate, land, precious metals, and crypto assets should perform well in real terms during a future recession. As mentioned in several earlier posts, Assist FX does not expect an imminent near term recession. Nonetheless, it would be a good idea to do some planning and perhaps gradually accumulate assets on a regular interval able to outperform traditional fiat currency bank deposits should you see the same risks that we do longer term. We are closer to an economic peak than a trough at this stage of the credit cycle.

Odds of a recession occurring in the next 1-3 years are likely about 50-55%. Beyond 3 years the odds increase dramatically as it becomes apparent full monetary normalization is no longer possible absent an unexpected renaissance of productivity and growth in an aging demographics world.

We are past the point of no return yet not quite to a dead end. That leaves us with an ideal opportunity to assess risks realistically now and plan for an uncertain future where USD could lose its dominant reserve currency role in the world and instead become part of a diversified currency basket mainly featuring SDR’s.

Caution on China Exposure As Credit Is Starting to Dry Up

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When the RBA decided earlier this week to hold fire on gunning for a gradual rise in interest rate expectations, surely it was considering this: China credit impulse with a 9 month lead is taking a dive.

In other words, very recent mothers-to-be shall be giving birth to their children in a notably worse Chinese economy than when said children were conceived. How much worse? Perhaps four PMI points worse, which implies GDP growth falling by about 1-1.2% from the current annual growth rate of 6.9%. This doesn’t imply a market crash but it does imply that fewer Australian businesses need to boost investment.

We like leading indicators at Assist FX — both quantitative and qualitative. While the future is always uncertain, analyzing it as accurately as possible is best accomplished with forward looking indicators and models. What we are seeing on the horizon in China is a controlled, modest deleveraging with a minor tail risk of accelerated bankruptcies. As the facts change, so will our models. For now, we remain cautious on China-sensitive financial instruments such as the Australian dollar.

Soft RBA Tone and Quiet China Liquidity Drain to Constrain AUD

The Reserve Bank of Australia expressed more caution than market participants expected in its monetary policy statement this morning.

The nuanced hawkish rhetoric shift by other advanced economy central banks recently, particularly from the RBA’s key commodity producer counterpart in the west, the Bank of Canada, was not imitated by RBA Governor Lowe. It was a highly balanced statement with several risk factors included, rather than including just a few boilerplate risks as could have been the case with less accommodative intentions.

Here are the policy statement highlights courtesy of Reuters (bolding is mine):

  • Indicators of labour demand remain mixed
  • Employment growth has been stronger over recent months
  • Some signs housing market starting to cool
  • Housing debt has outpaced slow growth in incomes
  • House prices rising briskly in some markets
  • Supervisory measures should help address debt risks
  • Various forward-looking indicators point to employment growth going forward
  • Rising A$ would complicate economic adjustment
  • Economic outlook supported by low rates
  • Wage growth remains low, likely to continue for a while yet
  • Inflation expected to increase gradually as the economy strengthens
  • Slow growth in real wages is restraining growth in household consumption
  • Business conditions, investment have picked up
  • Economic growth expected to strengthen gradually
  • Broad-based pick-up in global economy continuing

Why the caution? I believe the RBA is factoring in reduced Chinese liquidity into its forward looking models as China looks to reduce some froth out of its shadow banking sector. The PBOC has refrained from injecting liquidity via open market operations for eight consecutive days. This is already negatively impacting equity prices in Shanghai and will dampen near term demand for Australian exports as Chinese financing dries up.

AUDUSD is likely to see continued weakness into .7525 support. Rather than jumping on the AUDUSD selling bandwagon it is preferable to sell rallies against CAD and NZD.

USD Soft Patch to Set the Stage for Another Grind Higher in Asset Prices and Interest Rates

  • Bullish USD sentiment clearly became overly reliant on the Trump Administration’s desired agenda of tax cuts, deregulation, and infrastructure.
  • Due to the host of potential political scandals plaguing the Administration, as well as general political dysfunction in the US Congress, expectations of a pro-growth agenda being enacted this year have been significantly muted, though not completely discounted by Assist FX.
  • Assist FX still sees passage of a lighter version of market-friendly reforms in 4Q2017/1Q2018 limping past the finish line in what is becoming a non-consensus call. Sparring blocs within the Republican party will increase cooperation as political viability becomes increasingly threatened for the 2018 midterm elections.
  • In the near term, USD will struggle to stage sustainable rallies as political uncertainty takes its toll.
  • As financial asset prices in equities, real estate, and alternatives continue to inflate further into historically stretched valuation territory, it will place pressure on the Fed to remain on track for gradual rate hikes approximately once per quarter.
  • Long duration USTs will be pressured by lower real yields, lifting rates at the long end of the curve. This will contribute to moderate firming in USD in the medium term 3-6 month outlook.
  • Top risks to this view include a pronounced spillover effect from China’s debt deleveraging efforts resulting in global financial market instability, as well as any number of potential Trump Administration scandals escalating to such severity that the blow-back shifts the political landscape in favor of left leaning populists for 2018 and beyond. While these risks are currently underappreciated by markets, they are not our base case.

China’s Controlled Deleveraging

  • China has decided it is time to pull away the punch bowl for a little while.
  • There is a coordinated series of moves by China’s leadership to slow down the risk buildup posed by excess leverage.
  • The correction in both Chinese bonds and equities has thus far been met primarily with utter disinterest by advanced economy risk markets. Volatility levels are still crawling near historic lows across major asset classes and new all time highs are regularly being surpassed.
  • Still, if there is anything posing an out-sized share of global systemic risk it is China’s massive debt load.
  • Keep an eye on raw commodity prices in China as a leading proxy for  inflationary/deflationary asset price impulses. Iron ore specifically has had difficulties stabilizing as the Q4 2016 run up is moving closer to being fully erased on the way back down.
  • My base case is that China is not yet ready to unravel and this is a healthy process of mild deleveraging. However, it won’t take many more risk off days in China before it begins to spill over into developed markets elsewhere. If this situation does not materialize with increased stabilization by the middle of next week, there will be a tradable risk off wave. Stay tuned.

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Do Words Trump the Data? Probably Not Yet

“Our companies can’t compete with them now because our currency is too strong. And it’s killing us,” Trump told The Journal, referring to competition from China.

The Trump Administration wants to make America great again by transforming it into a manufacturing powerhouse like it was in the Post War glory days. Buy America, hire America. That’s not so bad really. Most Americans are generally on board with this patriotic slogan as long as its implications stop there. But then Mr. Trump takes things a step further with nonsense about the “strong dollar killing us.” By “us,” he means the 13% of the US economy reliant upon goods exports (as opposed to the other 87% more reliant upon domestic services and consumption). Mr. Trump surely isn’t referring to the more than 97% of Americans whose incomes are gained in dollars and whose spending power declines when the dollar’s does.

It is true that, in the near term, sharp increases in the dollar’s value can cause financial instability as foreign debtors struggle to pay back loans denominated in a strengthening currency relative to their own. It also causes the perception of lower US multinational corporate earnings as a portion of overseas earnings in relatively weaker currencies get converted back into stronger dollars at a lower nominal value on the income statement. This is as much a perception as anything because the same relatively stronger dollars that make foreign earnings look lower also have more purchasing power to lower future costs in those same regions.

In the medium to long term, there is absolutely no doubt that a strong domestic currency is in the interest of not just the citizens sharing it, but real GDP as well. Inflation tends to be lower, real incomes tend to be higher, and overall well-being tends to be notably higher in countries with strong currencies and low inflation. This fact has also been the stance of the United States Treasury for several decades. Is Mr. Trump challenging this stance or is he simply using fighting words to get in front of China (or others potentially) before it might need to devalue the yuan? Does he want to be able to say “told you so” if and when the yuan gets devalued with the intention of gaining enough political capital to impose tariffs against China? Who knows. It isn’t heartening that Mr. Trump doesn’t seem to understand how China is actually burning through currency reserves to prop up the value of its currency rather than hold it down as he alleges.

It comes down to this: will market sentiment return to favoring the dollar when US economic data surpasses expectations or have Trump Administration words materially damaged the perception of the long standing King Dollar policy in a way that it outweighs the data? Assist FX sees a continuation of data dependent sentiment for the dollar unless the Trump Administration makes an official move to target “currency manipulation” of trading partners using an executive order or proposed legislation. Markets are hyper-sensitive to Trump Administration commentary right now given all of the actions taken already in the first couple of weeks of its existence but the data will eventually move back into the driver’s seat.

Watch Out for These Two Macro Risks

If you must limit yourself to only two macro risks worthy of flaring up your insomnia they are these:

1.) Trade war contagion – Globalization and open borders are going out of style in mainstream developed market politics. Fast. In theory, trade reform can be targeted to narrow trade deficits, increase wages for the middle class, and make every developed country great again. In reality, there are tremendous risks of unintended consequences shaking the foundation of modern global economies. Modern economies function with tightly intertwined international supply chains. What would happen if every US import from Mexico, China, or even Germany rose in price by 15-20% at the stroke of a legislative pen? Would it really stop there? Would it not spark a wave of race-to-the-bottom retaliations, currency devaluations, and nasty inflation eroding real incomes across the board?  This is the top known economic and market risk as 2017 swings into gear. Pay attention to statements of pre-retaliation by public officials in trade-dominated economies.

2.) China’s currency reserves burn rate – China is burning through reserves at an alarming rate to prop up the yuan rather than suppressing it for competitive purposes as commonly alluded to by US President Trump. It has depleted more than 25% of its currency reserves in the past 1 1/2 years. It may only have another 6-18 months left before it is forced into a massive yuan devaluation of at least 15% to stop the bleeding. This would increase pressure on other Asian economies to also devalue their currencies, inflict trauma on US exporters and multinationals, compound default risk for dollar-denominated debtors, and destabilize financial markets. Imagine the turbulence seen in August of 2015 multiplied by at least 10; then tack on second-round effect multipliers. It is certainly worthy of being on the top macro risk short list.

Honorable mention goes to political election risk in the Eurozone this year. This will be a topic covered in more detail on this site in the future.