The Dollar's Reserve Status Under Threat: Is a Major Fall Looming?
Abraham George Macro Musings
As investors in the free world consider the future of the US Dollar, concerns about its reserve status are growing. While the dollar has not gained in status, it has likely lost its percentage holding from 70% to 60% in the last decade, or roughly 1% per year. However, the media's euphoria and panic may suggest a more drastic decline than is actually occurring.
It is my opinion that the dollar will gradually lose its reserve status, and it should. However, there is currently no other market that can absorb reserves from the dollar easily. A reserve currency is defined by the denomination of securities held in reserve by other countries, and only a large, liquid government securities market with a good rule of law can qualify as a reserve currency. The US is currently the only market in the world that can absorb the savings of major trading powers such as China, Japan, Taiwan, and Saudi Arabia. The other major government bond markets, such as Japanese, Italian, and German, do not have the same depth as the US market. Therefore, the dollar's role as a reserve currency is not immediately threatened. It will be a gradual process and not a sudden event.
There has been talk of China dumping US treasuries, sending US rates soaring, the US economy collapsing, and the dollar collapsing as well. However, this has not yet happened, as Chinese selling has been compensated by Japanese buying and domestic demand. It is worth noting that the 10-year notes are rallying.
History shows that the world has had various reserve currencies over time, including the Dutch guilder, French franc, and British pound. The US dollar took up the role of the dominant currency and reserve status after World War Two and Bretton Woods in 1944 when the US had 50% of the world's GDP and the largest reserves of gold. However, with the rise of China and its current status as the world's largest nation in terms of purchasing power parity, the tables have turned drastically.
The China-Arab summit that took place in Saudi Arabia on December 9, 2022, and the recent summit between Xi Jinping and Vladimir Putin on March 21 in Moscow, should have put a financial fear of God into the minds of Western leaders. China is taking advantage of frictions that exist between Saudi-US, Russia-US, and US-French relationships and could be moving towards a shared reserve currency status. It is too early to tell how this will play out, but I do not believe it will be the yuan, as China's authoritarian regime and the underdeveloped bond market will not encourage members of the free world to invest in it. However, with oil increasingly priced (traded/settled) in yuan and more trading partners using the currency, it could become an international currency and undermine the role of the US dollar.
The upcoming BRICS nations meeting hosted by South Africa in August 2023 will be important. About 20 countries, including Saudi Arabia, Mexico, Indonesia, Argentina, and UAE, have shown interest in being part of the BRICs. It is possible that a new currency could emerge based on GDP and backed by a basket of items, giving it more credibility, stability, and validity than just money printing.
Despite the uncertainties, it is clear that the ducks are lining up for a major fall in the dollar. Since the failure of Bretton Woods in the early 70s and until the GFC in 2008, the dollar has traded in five distinct cycles, with an average of 7.4 years, the longest being 8.8 years, and the shortest at 6.3 years. The period of QE after 2008 distorted this principle. The current bull cycle for the dollar has been especially long, lasting for the last 15 years, and it is not a promising look on the charts.
In fact, it looks increasingly like the top in the dollar was seen in October 2022. If that is the case, we are only five months into this downtrend for the dollar. The fundamental picture for the dollar is clearly negative, with the rate outlook swinging dramatically from tighter to easier by year-end, and the dollar's reserve status is now being questioned and challenged.
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Abraham George is a seasoned investment manager with more than 40 years of experience in trading & investment and multi-billion dollar portfolio management spanning diverse environments like banks (HSBC, ADCB), sovereign wealth fund (ADIA), a royal family office, and a hedge fund.