USD empire

Even though U.S. GDP as a proportion of global GDP has halved over the past 60 years to roughly 25%, U.S. Dollar (USD) usage still dominates global currency usage.

The Fed reports that as of the end of 2020 the USD accounted for around 60% of all globally disclosed foreign exchange reserves.

I am your father

Like Vader, the USD has become powerful and omnipotent. It’s now the father of all macro.

Post Bretton Woods (1944) it replaced gold as the benchmark to which other currencies would be pegged and effectively assumed the role of world reserve currency. Despite some twists and turns it remains the world’s reserve currency because of its liquidity and the depth of the U.S. treasuries market. Currently there are ~US$23.7 trillion in outstanding securities, with the largest group of holders being foreign and international which account for about 30% of issuance (refer SIFMA for further details).

The size and depth of these markets and ability to get in and out quickly is why people often say that the USD and Yen (tied to the world’s second largest bond market) are the world’s safe haven currencies.

But just like Vader, the USD has two faces and they are difficult to reconcile.

The outside face is strong and shiny and capable of tricking you into buying U.S. treasuries. After all, that’s been a safe haven for sovereigns, investors and traders over 40 years. But not so now.

And that brings us to its second face, Dollar Vader. This uglier face was recently unmasked by the Fed’s war on inflation. By lifting the federal funds rate too much, too quickly, too late and pursuing guidance for rapidly restrictive policy, the Fed has unleashed the dollar’s dark side. What I mean can be unpacked as:

Buying U.S. treasuries for safety (a trick of the force that worked for 40 years in a declining interest rate environment) does not work when yields are going up. While this won’t be forever, it is the case for the minute. Prematurely seeking refuge in treasuries is likely to lead to throat crushing losses.
Sovereigns, businesses and households outside the U.S. need access to dollars for financing, refinancing, trading and investing and almost all of them need to access expensive dollars. And for the weaker net importer countries sporting heavily geared sovereign balance sheets and weak demand drivers, they are feeling the full force of Dollar Vader as they spend more of their weaker currencies to buy more expensive dollars.

The empire strikes back

The chart below shows the rise of Dollar Vader since the GFC.

In numbers, the Ruble, Pound, Yen, Euro and Aussie have fallen 59%, 45%, 40%, 39% and 34% against it.

And in pictures…….

I haven’t included all major currencies due to lack of Fed data points. I’ve also excluded the Chinese Yuan as it’s pegged to the dollar, so it’s a false reading.

Also, at the time of the GFC the USD was buying 23 Russian Rubles and compared to March when it was buying 133 Rubles, it had weakened by around 82% against the dollar. But since March 2022 and Putin, it has strengthened with the USD now only buying 57 Rubles. While as of today the Ruble has lost 59% since the GFC, it should have been significantly more, but for the war.

Over the ‘GFC to now’ time period the USD has reigned supreme.

But it’s the second uglier face that’s of interest today. Essentially, Dollar Vader makes dollar denominated hard and soft commodities as well as factors of production very expensive, and it’s that kind of dollar exported inflation that’s as deadly to demand as the death star is to planets.

Dollar Vader exports inflation to weaker countries which in turn drives lower levels of aggregate demand, predominantly by making commodities more expensive.

We can already see that demand for most bulk, base and soft commodities (other than for certain battery and magnet minerals) has weakened due to Dollar Vader.

Here’s the proof. Apart from some limited perkiness in August, it’s been downhill since rate rises even in spite of Putin’s attack on Ukraine.

In time (and we don’t know when) lower demand will meet with lower supply from unhealed supply chains (which will hopefully repair, eventually) and a new demand/supply equilibrium at a lower price point will emerge.

To achieve this sustainably will require the Fed to sacrifice all-time low unemployment as it belts up (and down) the economy.

And then what about other countries? Maybe the only way to regain purchasing power will be to increase their official rates above the Federal Funds Rate and create a ‘carry’ to stop capital flighting to U.S. treasuries, and instead encourage investment in their own currencies and economies.

I have no idea, whether this will happen.

A new hope

Once inflation has been hobbled, the Fed pauses and/or USD swap lines are recalibrated to ease Dollar Vader pressure, Dollar Vader should be defeated and commodity prices should start moving up, all over again.

It should also mean that foreign currencies, particularly emerging and net importer nation currencies, regain purchasing power.

But that assumes we get there in one piece. It also assumes a sustainable non-Russian solution for European energy demand, i.e., something other than rationing or shuttering its massive manufacturing base.

In the meantime, keep a close eye on Dollar Vader. It might be lurking in the background for you, but it’s exporting inflation to almost every nation and driving the macro.

Mike