Snapshot to Part 1

The global financial system has long been characterised by the dominance of the United States dollar (US dollar). As the world's reserve currency, the US dollar has enjoyed unparalleled influence and stability in international trade, finance, and investments.

However, the COVID-19 pandemic has sparked significant shifts in the global economic landscape, leading to debates and speculations about the future of US dollar dominance. These shifts have been further underscored following Russia’s invasion of Ukraine.

In this blog, we will examine sentiments and perceptions surrounding dollar dominance before the pandemic and contrast them with today’s outlook. A final question for the future is posed at the end - make sure you read to the end.

But before you read on, this is the first piece in my new series of “Pre-COVID-19 vs. Today” that I’ll be writing over the course of July. I hope you enjoy the series.

Pre-COVID-19: The Indisputable Hegemony of the US Dollar

Prior to the COVID-19 outbreak, the US dollar's position as the dominant global currency was largely unchallenged.

This can be seen clearly in the US Federal Reserve’s international currency usage index 👇👇

During the period (and since the 1970s when gold backed dollars morphed into fiat) the world relied on the dollar for pricing commodities such as oil, conducting international transactions, and holding reserves.

Several factors contributed to the dollar's supremacy:

• Stability and trust: The US economy boasted immense economic strength, a robust financial system, and a history of political stability. These factors instilled confidence in the global community, making the dollar a safe haven for investors during times of uncertainty.

• Petrodollar system: The 1970s witnessed the establishment of the petrodollar system, where major oil-producing nations priced their oil exclusively in dollars. This arrangement further solidified the dollar's standing as the premier currency for international trade and investment.

• Network effects: The widespread acceptance of the dollar facilitated its usage and circulation. Many countries pegged their currencies to the dollar, strengthening its position and reinforcing the network effects that underpinned its dominance.

• Swap lines: Another element creating network effect, dollar liquidity, confidence and stability are swap lines. Swap lines are arrangements between central banks that allow for the exchange of one currency for another at predetermined exchange rates and maturities. The US Federal Reserve has established swap lines with several major central banks around the world, particularly during times of financial stress or liquidity shortages. I’ve written about this and the potential to weaponise swap lines before.

Changing Landscape: Post-COVID-19 Perspectives

The outbreak of the COVID-19 pandemic, with its far-reaching economic consequences, has accelerated discussions about the future of US dollar dominance.

Here are some noteworthy developments and opinions in the aftermath of the pandemic:

• Erosion of trust: The handling of the pandemic and the subsequent economic fallout led to questions about the US's ability to maintain its economic leadership. Massive fiscal stimulus packages and a growing national debt stack have raised concerns about the long-term sustainability of the dollar's dominance.

• Digital currency race: The rise of cryptocurrencies, most notably Bitcoin, has sparked discussions about the potential of digital currencies to disrupt the existing financial order. Central banks, including the Federal Reserve and our RBA, have started exploring the development of central bank digital currencies (CBDCs) to address the changing landscape. China already has one.

• Diversification of reserves: Central banks across the globe have been diversifying their reserve holdings, reducing their reliance on the US dollar. Some have increased their holdings of alternative currencies, such as the euro, Chinese yuan, or Japanese yen, to mitigate risks associated with a potential dollar decline. Some have been buying gold, writ large.

• Geopolitical shifts: The pandemic exposed vulnerabilities in global supply chains, prompting some nations to reassess their dependence on the US and the dollar. China, in particular, has accelerated efforts to internationalise its currency, the yuan, by forging trade and investment agreements that bypass the dollar.

• Flight to safety, currency demand and economic sanctions on Russia: In response to Russia's invasion, the international community, led by the US and its allies imposed economic sanctions on Russia. These sanctions limited trade and financial transactions with Russia (for many, but not all countries) and disrupted global supply chains which has had material inflationary effects on countries heavily reliant on imports from Russia and with trade ties with Russia. The search for alternative suppliers has created higher imports costs in many countries, leading to further calls for the use of multiple currencies to settle international transactions.

• Artificial Intelligence (AI): AI’s ability to analyse vast amounts of data, identify patterns, and execute trades with speed and efficiency and by influence trading volumes, liquidity, and price will likely lead to changes in market structures and the way currencies are traded. Potentially, this will affect dollar dominance. However, it is likely to be the advances that AI can bring to cross-border payments and remittances by facilitating faster and more cost-effective payments and remittances that could promote the use of alternative currencies or digital assets. This would likely impact dollar dominance in international remittances/payments. AI can also help facilitate (previously mentioned) CBDCs.

Eyes to the future: What-if?

Despite the increasing attacks on dollar dominance, there’s still no better substitute.

But here’s some food for thought.

What if the Federal Reserve in consultation with Treasury were to go down the path of long-term yield curve control (YCC) to keep interest rates low and Government interest costs affordable (like in Japan) - what effect on US dollar dominance might this have? 

It’s a big question and there’s a very reasonable probability of that scenario unfolding. So, here are some thoughts:

• Support for government debt: As a monetary policy tool, YCC is aimed at controlling interest rates on a specific segment of the yield curve. Under YCC, the central bank sets target levels for certain long-term interest rates and takes measures (buys bonds and bills, injecting money into the system) to keep those rates within a desired range. The objective is to influence borrowing costs for businesses and households, stimulate economic activity, and promote price stability. However, by implementing such a policy, the Federal Reserve could ALSO provide ongoing support for government borrowing, allowing the US government to continue financing its debt at favourable rates. Hmmm? This may contribute to maintaining confidence in the US dollar in the short term, as it ensures the government's ability to meet its financial obligations.

• Potential inflationary pressures: YCC, when combined with accommodative monetary policy, could result in increased money supply, and potentially fuel inflationary pressures all over again. And if the market perceives that the Federal Reserve's actions are leading to a sustained increase in inflation, it could undermine trust in the US dollar as a store of value. Heightened inflationary concerns could prompt investors to seek alternative assets or currencies, potentially challenging US dollar dominance and putting pressure of the Federal Reserve to increase interest rates (all over again) which would have a strengthening effect. On the other hand, AI might operate to increase productivity to such an extent that less people are required to do more work at ever decreasing costs, which would be deflationary.

• Market distortions and asset allocation: The implementation of YCC may distort market dynamics and lead to unintended consequences. By keeping long-term interest rates artificially low, it could create incentives for investors to seek higher yields in other markets or assets outside of government bonds. This could potentially affect the demand for US dollar-denominated assets and impact the overall valuation of the currency. The analogue here is again Japan. This is because of differentially lower yielding Japanese Government Bonds versus the yield achievable by converting yen to dollars and buying US treasuries. Perversely, if the US Federal Reserve did adopt YCC, it may sacrifice some Japanese demand for US Treasuries, which is turn would weaken the US dollar.

• Global perceptions and investor confidence: US dollar dominance is closely tied to perceptions of the currency's stability, credibility, and the overall health of the US economy. If the implementation of YCC is seen as a sign of monetary policy manipulation or a lack of fiscal discipline, it could erode confidence in the US dollar. Global investors and market participants may question the long-term sustainability of such measures and seek alternative currencies or assets, potentially diminishing US dollar dominance.

Net, net, the above scenario is likely to be neutral to weak for US dollar dominance.

And if you subscribe to that view and assign a reasonable probability to YCC, then it is likely we will see a lot more strength in the US dollar before it starts to decline over time. Timeframe unknown.

Conclusion

While the US dollar's dominance remains significant in the post-COVID-19 era, the pandemic has undoubtedly triggered debates and raised pertinent questions about its future. So too has Russia’s recent hostilities in Europe.

The erosion of trust, shifting geopolitical dynamics as well as the digital currency revolution, diversification of reserves and swap lines have all contributed to an evolving narrative.

AI has been given to the masses (via ChatGPT) and it will accelerate many of the above factors. There will be less people doing more work (with help from AI and autonomous machines) and exchanging value at the speed of light, in more inclusive ways, with a lesser reliance on US dollars.

Could this be enough to unseat the US dollar?

Maybe. But there needs to be a better alternative.

Maybe we will see a shift to a multi-currency basket convertible into digital currencies where programmatic rules tied to productivity (i.e., GDP) start to become dominant?

Perhaps.

While the path ahead is uncertain, it’s evident that the global economic order is in a state of transition, and as the world continues to right size and emerge from the pandemic epoch, it is crucial to monitor these developments and their potential impact on your business and investment portfolio.

See you in the market.

PS: “Pre-COVID-19 vs. Today” will return next Wednesday when we’ll look at global equities, then and now.

Mike