The US dollar can weaken but still remain the world's reserve currency

One puzzling aspect of the massive volatility over the past few weeks has been that US safe haven assets, namely the US dollar (USD) and Treasuries, have not exhibited typical risk-off behaviour. Instead of investors flocking to buy US Treasuries and remain invested in the USD, both asset classes have actually weakened. Other safe haven assets like the Swiss franc and the yen have seen the usual flight-to-safety bid, but why have the USD and Treasuries lagged?

 

The weakness in US Treasuries is linked to the precarious fiscal position of the US, the possibility of dumping of Treasuries by global investors, and a general unease about the policy direction of the US. However, there are various pulls and pressures, and it is not obvious that bond yields in the US will keep rising. Much depends on whether the US enters a stagflationary environment or moves into a recession.

 

For the USD, the trade seems more structural and clear. Unlike many, I don’t think the USD is going to lose its reserve currency status, as there is currently no alternative. The dollar continues to account for over 50 per cent of all trade invoicing and over 70 per cent of equities and bonds. Almost 90 per cent of all foreign exchange transactions have the dollar on one leg. This dominance will not go away easily. One must acknowledge that the US is weaponising the dollar and abusing its reserve currency status, but still the alternatives are years away from maturing.

 

However, in recent times, analysts like Stephen Jen and others have outlined a concept of the USD and other currencies having two shadow prices — one determined by the capital markets, and the other by the real economy, or Main Street, as US commentators say.

 

In most countries, these two values are largely the same. In the US, however, over the last 15 years, there has been a large disconnect, with the financial markets-determined value of the dollar being much higher than what Main Street needs, and dominant to such an extent that many now believe that the dollar is about 15-20 per cent overvalued.

 

As a hegemon, the US no longer derives its hegemonic powers from manufacturing and goods. China is the world leader in manufacturing, with 32 per cent share compared to only 15 per cent for the US. The US derives its influence from its dominance of the global financial system, capital markets, and the power of the USD as the world reserve currency. Financial markets are where the US is dominant, having delivered the best returns over the past 100 years — and truly exceptional returns relative to the rest of the world in the last 15 years. Its financial markets are the broadest and deepest, with the best governance. While the world has shifted to a multipolar landscape in terms of the real economy, with China and the European Union emerging as major players in goods and manufacturing, we still live in a unipolar world from a financial markets perspective. The USD and US markets remain the only game in town for anyone wishing to raise or deploy large amounts of capital. This has led to disproportionate demand for US assets. This demand has driven strong US asset performance and also caused the dollar to appreciate and become overvalued. Given the relative returns since the global financial crisis, it’s easy to understand why the term “American Exceptionalism” gained broad acceptance, and was meant to highlight the superior performance of US financial assets and the nation’s technological prowess. It is also a fact that while we saw exceptionalism in American financial assets and markets, over the last 15 years on most social indicators, be it life expectancy, inequality, poverty, or literacy, the US has actually regressed in relative terms.

 

The strong dollar has weakened the competitive positioning of the US across various industries. Manufacturing as a percentage of gross domestic product (GDP) has shrunk, dropping to less than 10 per cent, while labour costs in the US have become uncompetitive. For example, unadjusted for productivity, manufacturing labour costs in the US are about $55/hour, compared to $35 in Germany and $20 in Japan. This gap has widened over the last two decades. It’s no surprise, then, that companies like TSMC have stated that manufacturing in America is 40 per cent more expensive. Anecdotally, the US feels very expensive to visitors, and US tourists often find every other country cheaper, which are clear signs of USD overvaluation.

 

Clearly, the fair value of the dollar, as determined by Main Street or the real economy, is lower than what works for Wall Street. For US President Donald Trump’s reshoring policies to succeed, the USD will need to weaken. We seem to be going through a period where the market clearing price for the USD is moving from the higher levels driven by capital flows to a level that works for the real economy and makes America competitive again. The Trump administration has tried to frame this move from the financial markets shadow dollar price to the real economy-driven shadow price as prioritising Main Street over Wall Street. His policies are encouraging this shift.  This structural realignment can mean a 15-20 per cent depreciation of the USD, without the greenback losing its reserve currency status.

 

Another factor that investors have to bear in mind is the huge imbalance in asset ownership between the US and global investors. The US owes the world about $25 trillion, or foreigners own about $25 trillion in USD assets — more than Americans own in foreign assets ( Source: US Department of the Treasury). There is the risk of a sudden stop in foreign funding either as retaliation or a loss of confidence in the US policy direction. This imbalance used to be about 40 per cent of US GDP in 2017/2018, and has now crossed 85 per cent of GDP. This is a serious vulnerability, and signs of it are visible in the surprising rise in US bond yields during a period of market stress. Are foreign investors going on a buyers’ strike? The US Treasury faces massive refinancing needs — around $9 trillion to $10 trillion — due to the low duration of government debt. Continued foreign buying is essential to ensure this refinancing proceeds smoothly.

 

The case for a weakening USD is strong. The currency is overvalued on almost every metric. The US administration needs a weaker dollar for its reshoring agenda to work, investors are very overweight US assets, and American exceptionalism is finally being questioned. The dollar can weaken and still remain the world’s reserve currency — don’t confuse the two.

 

The writer is with Amansa Capital