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

dominant currencies throughout history 071717

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.

What the Market Overlooked in the Personal Consumption Expenditures Report

  • Most market analysts are pointing to the slight miss in May’s headline year-over-year PCE deflator reading of 1.4% vs. 1.5% expected and 1.7% previous.
  • What has been overlooked by most are the strong back-to-back personal income figures of 0.4% m/m in May and 0.3% m/m (revised from 0.4%) in April. While April was revised a tick lower, May’s rebound capped off an impressive two month gain of 0.7% in personal incomes.
  • This runs counter to the prevailing sentiment that the Phillips Curve is broken and wages are not picking up or at least holding their own.
  • The Fed has shifted focus recently, as they often do on a discretionary basis, to focus on financial stability after the epic run up in mega cap tech names, equity  valuations, and market complacency suggested market psychology was fostering an unhealthy rise in market bubble dynamics.
  • The core Fed FOMC members are now willing to overlook taming inflation for the time being as a 15% fall in the energy complex drags down PCE and CPI for the next few months. They still believe continued labor market tightening toward what is deemed to be “full employment” will eventually boost wages and keep inflation expectations on a steady projectory. Other central banks are following suit.
  • Assist FX sees the recent central bank turn toward slightly less dovish rhetoric as supportive of a more sustainable recovery. While asset valuations are still stretched and in bubble territory on a longer term basis as regularly discussed on this site, letting some pressure out of the “everything bubble” is actually productive overall.
  • Letting asset valuations and house price-to-income ratios skyrocket unchecked by a tightening reaction function in monetary policy would be one major catalyst capable of changing our S&P500 bias to negative as prices become increasingly stretched like pulling a thinning rubber band.
  • Assist FX sees moderate Fed action to trim asset purchase reinvestments in September with another 25 bp Fed Funds target increase in December.
  • Our equity, fixed income, and USD bias remains neutral.

Euro Set to Rise on Reversal of Deeply Negative Bond Yields

Real interest rates are deeply negative in much of the Eurozone due to the combination of interest rate repression by the ECB’s bond buying program plus above-target inflation.

Take a look at the real 10y German bund yield below.

bund - cpi feb 2017

As I have pointed out, the further behind the curve a central bank gets, the harsher the snap back toward normalization is once the process to normalize is anticipated by market participants. No central bank is further behind the curve right now than the ECB.

Investors are pricing in two or three 25 basis point Fed rate hikes this year. No such expectations exist in the Eurozone due to Mario Draghi’s persistent, stubborn denials of even discussing normalization with the Governing Council—yet. We may be at a turning point in market expectations for the euro as the severity of political risk subsides.

The 2yr yield spread divergence in US-German government debt is at extreme levels of 221 basis points. You could cruise a row of mega tanker ocean liners through that spread. This suggests a higher EUR/USD if and when the spread narrows to historically normal levels, but most likely long before then. The 10y Bund real interest rate yield is so deeply negative during a period of increasing economic activity and inflation that probabilities suggest a brisk reversal higher in yields the moment markets start pricing in a post-QE Europe.

The exact timing of when the yield spread will close is not as critical as knowing what will happen when it does. Once the sea tide resides back from the beach, it will be apparent holders of European government debt were swimming without bathing suits. They will likely be standing along side short sellers of the euro who will also be… exposed.

In summary, now is probably as good of a time as any to make sure you aren’t holding long European bonds that look and sound an awful lot like time bombs. The same could be said for short euro positions. Long EUR/USD and EUR/GBP entries on political fear-based dips will provide favorable asymmetric risk/reward opportunities.

Market Impacts of Economic Populism and Elevated Debt Levels

The politics of trade protectionism, nationalism, and anti-immigration are the match which will ignite dormant inflationary gasses bubbling underneath the surface after years of short-sighted monetary policy experiments.

Governments have failed for several years to enact meaningful structural reforms that would set economies on a more sustainable path. This is just now beginning to lead to the realization of painful, inflationary solutions. Losses in real wealth and spending power for many advanced economy citizens in the name of “economic competitiveness” and “growing out of debt” are under way. Central banks are somewhat subtly engineering an inflation overshoot as it is implicitly understood that government gridlock, corruption, and incompetence are preventing wiser legislative solutions from coming to fruition. Central banks have been “the only game in town,” as coined by Allianz chief economic advisor, Mohamed El-Erian. In other words, growing out of debt with real growth, innovation, and productivity gains is much less likely at this point than inflating out of it with falling real wages, lower standards of living, and stagflation.

Real average hourly earnings in the US fell by 0.5% in January versus the prior month; nominal wages rose by 0.1% while the BLS CPI-U Consumer Price Index increased by 0.6%. Even excluding energy, nearly any measure of consumer prices leads to a trend of deteriorating real incomes and saving rates going forward. Bank of England Governor Mark Carney has warned of accelerated losses in purchasing power on the way for the United Kingdom.

While the UK’s 20.5% year-over-year manufacturing input price inflation in January was largely inspired by pound sterling depreciation after voting to leave the European Union, the reflation trend is a global phenomenon. Germany, Norway, Sweden, and countless emerging markets including Mexico, China, Chile, Turkey, and Egypt, are experiencing a pace of wholesale (PPI) price increases faster than has been witnessed since at least 2011. PPI increases of this magnitude are generally a leading indicator for CPI to follow suit, though wholesale businesses will absorb a portion of the input cost increases through margin contraction.

I have been warning about building inflation risks for the past couple of years. Contrary to what new Keynesian economic advocates will have you believe with their gravity and logic defying models, there exists a simple mathematical problem of too much debt and not enough productivity to legitimately grow out of it in developed nations with aging demographics.

Prominent demand-side economists such as Larry Summers have been advocating currency debasement, money printing, debt-fueled fiscal stimulus, and interest rate repression continually since the financial crisis. Paul Krugman famously called on then-Fed Chair Alan Greenspan to create a housing bubble in 2002 to replace the .com bubble bust. This cyclical mentality of monetary bubble manufacturing has been blind to the secular economic rot festering underneath those same policies. It has also had unfettered control of the levers within the world’s most powerful central banks for the past 20 years. Financial history books will eventually hold these highly flawed policies and their proponents accountable for doing little other than fueling the next great bubble—the credit bubble. Or, as I alternatively call it, the global QE bubble.

Keynesian economists calling for debt-financed spending, ultra-easy monetary policy, and demand-pull inflation during a period of economic stagnation is nothing new. It isn’t only the usual suspects, however, singing the inflationary gospel now. That is why we are at such a significant inflection point. The populist right is winning political momentum and its policy prescriptions are astoundingly inflationary—border taxes, import tariffs, currency debasement, immigration restrictions limiting the labor market supply, etc.

Economic populism is credited with giving birth to the new political paradigm. Its recent “scalp prizes” were supporters of the UK staying in the European Union and the entire US political establishment. Lines between the traditional political left and right have become blurred in the developed world. Right wing populist candidates are closely vying for power in the least likely places on earth one would expect—the Netherlands (Geert Wilders) and France (Marine Le Pen).

Established politicians and their party infrastructures are more at odds with each other than they have been in decades. Yet, grass roots supporters of what are typically opposing parties have converged as strange bedfellows in supporting several key areas of common ground: reforming global trade rules with the intention of better protecting their own domestic workers, reducing cronyism within big government and big business, decriminalizing marijuana, and protecting civil liberties from government overreach, to name a few.

US President Donald Trump has lashed out concerning a too-strong dollar and flirted with altering a decades-long US strong dollar policy. France Presidential Candidate Marine Le Pen wants to leave the euro currency bloc, take control of the central bank, kick out the immigrants, and print money to fund social spending; and this is coming from someone widely considered to be of the political right wing. What could possibly go wrong? This has not gone unnoticed in the FX market or the French bond market. I’m afraid we haven’t seen anything yet, however.

These inflationary macro trends will continue to surprise many, even if Le Pen is not victorious in the France elections this year. The easy monetary policy leanings of the establishment-left and nationalistic fiscal policies of the populist-right are in alignment. They are both clamoring for a wave of higher consumer prices to erroneously “fix” structural problems of high debt and low labor productivity. It is completely illogical and will only have the opposite effect, but that is beside the point.

I sensed a stronger populist undertone than given credit by the press before the UK referendum to leave the EU and before the US presidential election. My base case doesn’t currently have Marine Le Pen winning the France presidency this year, but there is little room for error in the upcoming election season in Europe. Economic populism is here to stay due to the alignment of interests between grass roots supporters of opposing parties against political elites in general.

Punishing the globalist-minded political elites who have presided over declines in living standards for middle and working class Average Joes throughout the developed world is no longer exclusive property of the hard left. The populist right wants to make its dent in the elites’ armor as well. The result of anti-elite political sentiment will have profound impacts on financial markets for the next several years and some of these impacts are relatively predictable.

Behind the tire marks of the new anti-elite political paradigm exists a trail of how we got here. Gross mismanagement of government budgets globally and the inability of labor to share in the economic gains created during the previous period of high productivity have contributed to a deep structural hole that might prove too deep to escape with a “healthy” type of growth. This is especially the case given the drop off in productivity in recent years and aging demographics. It has also created outrage amongst the masses who feel duped for trying to play by the same rules the elite class gamed in order to gain even more wealth; ie, the carried interest deduction allowing billionaire money managers to pay lower tax rates than electricians.

The current hot topic of “low productivity” is often lazily discussed as if it is the reason real wages have been stagnant (or falling) for decades. Low productivity is more of a post-Great Financial Crisis phenomenon probably caused by a misalignment of corporate incentives. With Zero Interest Rate Policy (ZIRP) and central bank quantitative easing (QE) flooding the capital markets with fresh cash, why invest in new equipment to improve worker productivity when you can simply borrow for a negligible cost and use the cash to immediately fund common stock buybacks, dividends, and M&A? Excessively easy monetary policy distorted market dynamics and reduced incentives to increase productivity. Additionally, governments used the temporary benefits of monetary stimulus as cover to avoid taking more unpopular measures to improve their structural situations.

A decade of global central bank activism paired with several dysfunctional governments did not permanently address very many structural issues. What it did is limit the immediate severity of the 2008/2009 financial crisis, inflate asset prices to bubble territory, boost employment mainly for lower paying service sector jobs, and change the composition of the next recession to an inflationary debt reset rather than a deflationary bankruptcy-based debt reset, thus destroying responsible savers to the benefit of debtors.

What kind of a market environment will persist in a political climate of economic populism combined with excessive global debt? Real wages will take a beating initially, as will fixed income markets. Equity indices will be tugged higher on the illusion of inflated corporate earnings and then yanked lower after resulting interest rate spikes. FX rates will have multiple “Brexit-esque” caliber events, causing pockets of illiquidity and displacements in rates. A targeted Chinese yuan devaluation of 15% or more within 1-2 years is likely as one prime example. Any implementation of border taxes or tariffs designed to protect domestic workers will likely be met with retaliatory actions that will greatly harm those same workers, unless the new trade rules are negotiated and agreed upon by both sides. Bilateral trade deal negotiations and politics could be the chief drivers of global markets for the next five years in the same way monetary policy divergences drove markets in the past five years.

The best case scenario is governments use a period of unsustainable increases in budgets and financing costs over the coming years as political cover to get leaner, more efficient, and more responsive to the needs of their citizens (hopefully this doesn’t cause readers to erupt into spontaneous laughter). In a glass-half-full world, wages will eventually catch up to price increases. Those who are unemployed, retired, renting their primary residence, net savers, or whose incomes are not closely tied to actual inflation will feel like they were on the wrong side of a crash. It probably won’t be a traditional nominal price crash so much as a crash in real terms; however, there could be flashes of both.

Ultimately, the same forces that have always been responsible for real wage increases and higher standards of living still hold true: high productivity, broadly enjoyed technological innovations that lower costs without displacing too many workers, and a peacetime dividend enjoyed during times of no major war conflicts. Does it seem like we are headed toward this scenario?

Remember this: when someone tells you the surest path to economic prosperity involves devaluing your savings, lowering your real wages, and paying down old debt with new debt—run away and call the police—someone is trying to rob you.

ECB’s Inflation Target Hit Early: Time to Move the Goal Posts

The Eurozone Consumer Price Index registered an increase of 1.8% year-over-year in January versus December’s reading of 1.1%. This means the ECB’s inflation target mandate of “close but below 2%” has effectively been satisfied at least a year earlier than intended.

Next comes a series of goal post moving exercises. Policy makers and central bankers in Europe desire continued stimulus pumping to help limp past the banking crisis in Italy, the ongoing debt crisis in Greece, and significant political risk posed by elections in France, Germany, and the Netherlands.

Expect central planners in Europe to disregard the steepening inflation trend for as long as possible. Public discourse will gravitate toward new arguments downplaying headline CPI. These will include shifting focus to core CPI, blaming transitory effects from higher energy prices, highlighting unfavorable base effect comparisons from the prior year, and potentially even fears of trade barriers constraining future global growth. The ECB will get further behind the curve to the chagrin of Germany. Bullish pressure will continue to boil hotter for the euro currency unless politics get in the way.