Requiem for the dollar?

The United States’ attempt to rebalance the global economy to better serve its interests has resulted in the flight of capital out of the country.

The primary consequence of this effort has been a declining dollar and rising Treasury yields at the long end of the curve, between 10 and 30 years. 

Over the past year, we have made the case that any policy that devalued the dollar or sought to end its status as the world’s reserve currency would harm American businesses and consumers.

Arguments that the dollar is overvalued because of its reserve status or that it is in America’s interest to end the greenback’s reserve status are erroneous.

Those ideas, when translated into policies like the new tariff regime, are causing a general de-risking among large institutional investors and global central banks.

Now, for the economic carnage to come to an end, it will be necessary to restore confidence in both the dollar and Treasury securities.

There is precedence for this kind of repair; consider the period following the abrogation of the Bretton Woods agreement by the Nixon administration in 1973 and the near collapse of the global financial system in 2008.

A tipping point

U.S. equity markets have tumbled recently, while bond and money markets are contending with the prospect of recession, increased inflation and the need to cover margin calls.

There is a growing risk that dollar-denominated assets will continue to unwind as the attractiveness of U.S. assets fades and the safety of U.S. investments is put at risk.

The most visible sign of the trade shock and global disarray is the free fall of global stock markets.

The shock of instability and the loss of wealth point to a global economy at a turning point.

More pertinently, the correlation between yields and the exchange rate of the dollar has broken down, resulting in visible gaps in the pricing of dollar-denominated assets like Treasurys.

Under such conditions, the bid-ask spread for such assets widens and markets do not function properly as liquidity dries up.

Price discovery is nonexistent, creating “air pockets” in markets in which assets plunge in value. In the case of Treasurys, that turmoil sends the yield soaring, creating a negative feedback loop into valuation of the dollar and causing it to plummet. 

In short, that is how capital flees the United States, as long-term skeptics of the dollar proclaim its requiem across global markets.

In the near term, we see so-called hot money investments in U.S. financial assets being less attractive.

This decline would occur if U.S. short-term interest rates were forced lower because of a recession. In the long run, we see the potential loss of confidence in U.S. institutions and a growing reluctance to invest in its economy.

Foreign direct investment is defined as a purchase of 10% of more of the stock of a U.S. corporation, which is more likely to be hard money as opposed to short-term speculative investments.

During the recovery from the financial crisis and particularly in the post-pandemic era, FDI has been flowing into U.S. corporations, pushing up the dollar.

The strength of the dollar creates the means for U.S. households to consume foreign goods, while dampening inflation and generating high returns in dollar-denominated investments.

The dollar index lost nearly 10% of its value from the week before the January inauguration through mid-April.

This would not be the first time that the dollar depreciated because of a loss of confidence in the U.S. government.

The most recent notable example was the dollar’s depreciation in the run-up to the financial crisis. That decline was followed by a period of austerity and government dysfunction that kept the dollar trading between $1.20 and $1.40 against the euro from 2008 to 2015.

Since 2015, the dollar has benefited from a thriving U.S. economy that has attracted both hot money investments and foreign direct investment in U.S. corporations. That increase kept the dollar trading within a range centered on a $1.12 average versus the euro.

The dollar remained attractive, benefiting from higher U.S. interest rates compared to the other developed economies and the higher returns of investing in U.S. industries.

But that support is waning, with Europe and the UK taking the lead by investing in infrastructure and defense.

How long the dollar retains its strength will depend on what investors think about the safety of a dollar-denominated investment. To that point, the dollar depreciated against the euro by 11% Jan. 10 through mid-April, breaking above its $1.12 equilibrium and its 10-year average.

In the longer term, and while the dollar would ordinarily benefit from its safe-haven status in times of stress, it has become harder to assume that status will last forever.

To retain that status, the American economy needs to be willing to be both the consumer and the lender of last resort even as it negotiates with its trade partners and confronts its adversaries.

The trade deficit is a function of domestic spending and savings and not the valuation of the dollar or its global reserve status.

The takeaway

Neither the trade deficit nor the dollar’s recent round of overvaluation is sufficient reason for the currency reserve status of the dollar to be sacrificed as a matter of public policy. That move would be tantamount to the greatest financial debacle since Chancellor of the Exchequer Winston Churchill put the UK back on the gold standard about a century ago, resulting in a lost decade of deflation and unemployment.

The U.S. cannot expect to remain the center of the global economy if it chooses to withdraw into fortress America.