Three key levers:
- The US objectives and its success or otherwise in pursuing those objectives
- Organic demand from the rest of the world as well as induced demand, and the levers and factors that influence each
- Factors unrelated to the dollar driving other currencies, impacting the dollar’s relative attractiveness
US objectives:
- #1 Maintaining the reserve currency status of the dollar by ensuring substantial global demand for dollars
- #2 Limiting the resulting trade deficit which has led to dependence on other countries (primarily China) and to a structural weakening of the US economy which undermines US power
- These two objectives are fundamentally contradictory – improving the trade deficit calls for a weaker dollar, but a weakening dollar limits global demand for the currency, risks inflation and capital flight, and can threaten its reserve currency status
- The solution is projecting strength, stability and maintaining a high level of trust while addressing the trade deficit either through tariffs, currency interventions or accords with other countries (an agreed revaluation of currencies is not as damaging as the market’s loss of confidence in the dollar)
- Because of US policy choices (leveraging the currency as a policy tool) and the erosion of trust due to expanding budget deficit, growing debt, and apparent policy gaps highlighted by inconsistent strategies and frequent policy reversals, the US is less able to achieve its objectives
Dollar demand:
- Nonetheless, there is substantial built in global demand for dollars and this will only erode gradually over time
- Although technically the “petrodollar” ended when Saudi Arabia chose not to renew its agreement with the US and started accepting other currencies, dollar’s dominance in the oil trade remains, not least because most contracts, exchanges and financial instruments are dollar based
- The majority of foreign debt is dollar denominated, creating substantial demand for the currency to service and repay the debt
- Network effects and market inertia ensure that the dollar’s decline will be slow
- The SWIFT system (the most widely used crossborder payments network) – although in theory neutral and currency agnostic – has shown high compliance with US geopolitical demands, furthering the strategic power of the dollar; alternative systems developed by China and Russia as well as decentralised alternatives are growing rapidly, reducing SWIFT’s dominance, however, this also is a gradual process
- There is substantial retail demand in less developed countries for dollars against the backdrop of weak and depreciating local currencies or high inflation – the US administration believes that dollar denominated stablecoins can serve this demand and reverse the dollar’s eroding reserve currency status, and is actively promoting the expansion of the dollar denominated stablecoin market and encouraging the speedy passage of stablecoin legislation
- US assets continue to represent attractive investment opportunities, and translate into strong capital flows, including both direct investment and purchases of US equities, corporate bonds, and other securities. While international demand for US treasuries is declining, tariffs and protectionist policies incentivise direct investment and the US economy’s historically superior GDP growth relative to other Western economies is expected to persist, implying better returns (and therefore demand) for US assets
OUTLOOK
Overarching long term trend of dedollarisation
The trend for dedollarisation has been in motion for some time. The US leveraging its currency as an international policy tool (putting countries in a so-called “dollar debt trap” causing economic instability, and resulting in deals and asset purchases that disproportionately favour the US, as well as geopolitical intervention through sanctions or seizing dollar reserves) has given strong incentives to other countries to find alternatives.
An increasing portion of bilateral trade is settled now in local currencies, and the use of the euro (mostly in trade involving Europe), the yuan (especially among Belt and Road Initiative partners), and in some cases, cryptocurrencies is increasing.
Similarly, the dollar’s share in global reserves has been on a steady decline, dropping from 70-75 percent in the early 2000s to around 55 percent now. The dollar’s decline has not been offset by significant increases in the euro, yen, or pound, but rather there has been a rise in non-traditional reserve currencies, such as the Yuan, Australian dollar, Canadian dollar, Korean won, Singapore dollar.
Meanwhile the BRICS are working on a new trade and settlement system – with less focus on the creation of an alternative reserve currency but rather a new multicurrency system and a multipolar financial system, supporting the emergence of a new “multipolar” geopolitical world order.
In parallel with these trends, trust in the dollar is showing signs of erosion as US debt balloons and the budget deficit widens. Recent policy failures and reversals (eg on tariffs), missing stated strategic goals (such as bringing down bond yields), and public statements such as challenging the independence of the Federal Reserve have culminated in a “Sell America” trade, with the result of a sharply weakening dollar. As Warren Buffett announced his retirement, one of his parting shots was to say that the dollar was “a currency that was really going to hell”, mostly based on US fiscal policy and the incentives that point to a continuation of the adverse trends. However, we should note that the “Sage of Omaha” always had very long term investment horizons so his view on the dollar should also be taken as a long term view.
De-dollarisation is an overarching trend that will continue, in parallel with the decline of US global primacy. Should the US continue on the path of forcing the use of the dollar, for example President Trump pushing for 100 percent tariffs on countries that consider replacing the dollar as reserve currency, and attempting to extend global influence through political pressure, military intervention or economic measures, the incentive for countries will be ever greater to find ways to move away from the dollar.
If the US changes tack and accepts a place as a significant but not hegemonic power in a multipolar world, the dollar’s role will also decline to reflect a new distribution of geopolitical and economic power. The latter path would serve US national interests better, however, the signs are for now that the US remains on the former path.
Medium term bullish
Despite the long term trend of a decline in the dollar’s use, a number of factors are likely to shore up the dollar over the medium term.
This includes the remaining high demand for dollars arising from the substantial amount of dollar denominated debt and continued significant use in trade and settlements.
Additionally, while the US has been pursuing policies that moderate the dollar, putting global hegemony ahead of the interests of the US economy, a lot of these policies have hit a wall and reality is forcing the administration onto a more pragmatic path. For example, aggressive tariff policies, including instigating a trade war with China appear to have given way to a more reasonable approach where a gradual reduction of the economic dependence on China and a reindustrialisation of the US can be achieved. Following such a path would be positive for the dollar.
Additionally, rates in the US are expected to remain higher than in other Western countries for a number of reasons (such as the expected inflationary impact of tariffs), and supporting the dollar’s status as a reserve currency may also factor into these reasons. Beyond nominal interest rates, the US also has higher real rates than most advanced economies.
Furthermore, a differential in GDP growth outlook continues to favour the US over other Western countries, further supporting the dollar.
Short term
Currently the decline in confidence in the US administration is depressing the dollar and the “Sell America” trade is in play.
When market sentiment bottoms, the key short-term question will be whether we see positive policy pivots such as we have seen with the tariffs recently and interventions that support the treasury market.
Ultimately, we expect market sentiment towards the dollar to eventually stabilise and a bullish trend to resume over the coming months.
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