The Dollar’s Long Life

The Days Ahead:

• Earnings reports and the Fed meets

This Week:

• A strong dollar is good for the U.S….mostly
• How strong is the dollar?
• Foreign exchange market: it dwarfs all other markets.
• What it takes to be a reserve currency.
• Should the U.S. have a weak dollar policy?
• What can the U.S. do to weaken the dollar?

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Strong dollar or weak dollar?

Every few years the status of the U.S. dollar hits the headlines. We hear about its privilege, strength, inevitable decline, debasement, comparisons to the Roman Empire, dogs and cats. Last week we heard much talk about the dollar and whether it’s too strong, about right and what to do about it. It’s not an easy argument to follow. We’re taking a different approach this week to try and make sense about where the dollar is heading.

There’s been talk about penalizing countries who no longer want to peg (or attach) their currency to the dollar, or use the dollar in trade. We’ve also seen a renewed questioning of whether there’s a benefit to the dollar’s reserve currency status.  In Milwaukee last week, there were not only overt calls for a weaker dollar but calls to keep the dollar as the world’s currency.

If those points sound contradictory, that’s because they are.

We wrote about the dollar’s reserve status a year ago and concluded that no other country has the means or desire to take over the role. That remains our view but things are more complicated today. Let’s go through some points.

Is the dollar strong?

If we look at cross currencies, it’s hard not to say, Heck yeah, the U.S. dollar is streaks ahead. Since the beginning of 2020, the dollar is up 50% against the yen, 13% against the euro, 35% against the Mexican peso, and 24% against the South Korean won.

But a simple measure of cross rates does not tell the whole story. For that we need to look at this:

The black line is the U.S. dollar index. It’s no more than a trading tool with a basket of highly tradable liquid currencies. It’s made up of the euro at 57%, the yen at 14%, sterling at 12% the Canadian dollar at 9% and the Swedish krona and Swiss franc at 4% each. It’s up around 6% since Covid-19. But these countries make up 26% of the trade with the U.S. so the index is not useful as a measure of broad dollar strength. It’s the most quoted measure in the news but it’s the least helpful to understanding the dollar’s value.

The blue line is the Fed’s trade-weighted index and it looks at all the countries the U.S. trades with in both goods and services. Services include things like airlines, legal services, banking, insurance and travel and make up 26% of all trade. The U.S. enjoys a substantial surplus in services trade of over $280 billion a year. The top weightings for this trade-weighted index are the euro, at 19%, Mexico at 14%, Canada at 13%, China at 13% and Japan at 5%. No other country carries more than a 3% weight. The index is up 3% since Covid-19.

Finally, the green line shows the real trade weighted index. This is the same as the trade weighted index but makes an inflation adjustment for each currency.

How does it work? Well, if a country experiences high inflation, for example, Mexico’s 35% inflation in 1995, the currency would fall by the same amount against, say, the dollar which may have had 0% inflation that year.

If the Mexican peso falls less than 35% against the dollar, it can be said that the real rate rose. If it fell more than 35%, it weakened. Since 2006, the nominal dollar index has risen 24% but the real dollar index has risen 17% suggesting the dollar has not risen as much in real terms once inflation differences are considered.

It’s not a precise science and economists argue whether one should only use tradeable goods or domestic goods or both. But it makes sense to adjust for differences in inflation and the real trade weighted index has a role to play. On a real trade weighted basis, the dollar is up around 4% since Covid-19.

The short answer is, yes, the dollar has been strong since for the last 10 years. The last time it was this strong was in 2002 and before that in 1986.

Why is the dollar strong?

Before we dive into the strength of the dollar, we’ll detour into the “exorbitant privilege” of the dollar. The dollar was so described in the 1970s because it became the reserve currency of choice. What’s a reserve currency? It’s a currency held by central banks and commercial banks for large international transactions.

Any currency can be a reserve currency if it meets four requirements:

One, that it is stable against other currencies, two, it is the currency of a country that holds an important share of world trade, three, it has an efficient foreign exchange market and, finally, it is convertible.

That rules out, in order,

1. Any currency in which the central bank is not independent of the government
2. A country with minimal trade volumes
3. A currency with capital controls or limited convertibility
4. A currency with a fixed or targeted exchange rate

Few currencies meet all four requirements and even fewer want to. China for example, meets #2 but fails on the other three. India fails on #3 and sometimes #4. The dollar, euro, yen, sterling and Swiss franc meet all four.

Reserve currency status means that foreign central banks want to use your currency. As of March 2024, 58% of all official reserves are held in dollars, 20% in euros, 6% in yen and 5% in sterling. No other currency is more than 2%.

It also means that 65 countries peg their currencies to the dollar. Some, like Ecuador and 16 others, only use the U.S. dollar. Another 12, including Saudi Arabia, Jordan and Hong Kong, are pegged to the dollar with a fixed exchange rate. Others, like China, have a floating peg, meaning they aim to track the dollar but with variability.

The dollar’s privilege also means that commodities and goods are priced in dollars. Oil, of course, is only traded in dollars. If Nigeria sells oil to Spain, the price is fixed in dollars and the currency flow goes something like this: Spain sells euros to buy dollars, which it deposits in an account for the Nigerian National Petroleum Company (NNPC). They then sell the dollars for Nigerian naira for domestic use or keeps the dollars to buy goods and commodities priced in dollars. None of the oil came anywhere near the U.S. but the only way for Spain to buy and Nigeria to sell is to use the dollar.

The world trades one hundred million barrels of oil daily. Every day, $20 billion dollars exchanges hands. Every day, the world trades 60 billion cubic feet of gas, and another $20 billion exchanges hands. Copper trades $90 billion daily just in the U.S.. Gold trades $160 billion and aluminum $7 billion. It’s the same for every food, grain, livestock and metal commodity. They’re all priced in dollars.

There are a few workarounds if you’re on a sanctioned list. Russia barters physical oil priced in dollars for weapons. But no cash changes hands. In the EU, both parties will use the euro. But otherwise 90% of the world’s $32 trillion of annual trade includes a dollar invoice.

The privilege is thus that everyone needs dollars. U.S. economic policy may not always be aligned, deficits may be wide, or the current and trade accounts worsening. But the U.S. does not borrow in other currencies. It buys all its imports in dollars. It invoices its exports in dollars. It is not going to face a balance of payments crisis. Nor is it going to default. Dollar liquidity is abundant and the U.S. is the lender of last resort whether it’s bailing out countries, banks or markets. The idea of privilege seems outdated but the dollar plays a role that no other country can or wants.

How does the Foreign Exchange (FX) market work and how does it support the dollar?

The FX market, where one currency is exchanged for another, is not like other markets.

First, it is very big. It trades around $7,500 billion a day compared to the S&P 500 of $250 billion and Treasuries of $864 billion, although that number is inflated with some $40 billion of bills maturing every day which need replacement. Some 21% of all debt is issued in  bills.

Second, one may wonder why the daily trading in the FX market is 7% of annual global GDP and 17 times larger than the world economy. It’s because every FX trade is double counted. If I want to exchange $100 for euros, someone else has to buy the euro to sell to me. There are two transactions. Equity volume only counts the number of shares traded on either a sale or purchase.

It gets more complicated. Auto parts for a car made in Georgia may cross the border eight or nine times before final assembly. The engine is made in the US, sent to Mexico to attach a drive train, railed to Canada for a sub-frame and back to the U.S. for final assembly before being shipped to Spain for final purchase. Each trip involves at least two sets of FX transactions. In another example, the iPhone carries products from 43 countries. Each part may cross numerous borders and requires multiple payments before final shipment and sale. (** See footnote).

Even a trade that starts and ends in other currencies will use the dollar. A bank buying South African Rand for a Singaporean client will cross the trade through the dollar. There’s is no viable Rand/Singaporean dollar market. The liquidity is always via the dollar. Every other pair trade will have insufficient volume. The dollar provides liquidity.

Third, swaps, options and forward contracts are 65% of all transactions and 39% are for future delivery of one month to one year. If a utility company in the U.S. buys coal from Australia for the next year, it will want to lock in exchange rates for as long as it can. Banks will offset the risk with hedged trades at the full-face amount of the original trade. That’s in contrast with stocks and bonds where forward contracts like options are bought using only a fraction of the notional or trade amount.

Anyway, the FX market is huge and complex and the plumbing, frequency, and size of the trades means that the top reserve currency will be very hard to displace.

How do you weaken the dollar?

We’ve already seen that the dollar has been much stronger in the past. But if a weaker dollar became policy, there are a few ways to make it happen.

Talk. There may be a wall of money clamoring for dollars but if a country really wants to talk down its currency, it can. It may take repeating but if the president of the United States says that the dollar is too strong, and that he doesn’t want people to buy it, it’s likely to start slipping. Chair Powell can move the Treasury market with a few choice words. The president could do the same for the dollar.

From there it gets harder.

Capital controls. Foreigners own around $8 trillion or 31% of U.S. public debt. They own $13.7 trillion in equities, around 26% of the value of the S&P 500. They also own $12 trillion in U.S. corporate debt and $5.3 trillion in direct investment, which is basically multinational investments in the U.S.

Capital controls would dampen demand very quickly. But the U.S. corporate sector also owns $7.7 trillion of overseas investment and $14 trillion of portfolio holdings. It’s likely that any capital controls would invite retaliation in a zero-sum gain.

The U.S. also borrows overseas.

In the chart below, we show foreign buying of U.S. assets and U.S. companies’ overseas debts.

The green line shows the U.S.’s gross external debt position at $26.5 trillion. This is money owed by U.S. government, banks and companies to overseas lenders. The net amount is $21.3 trillion, which is around 78% of GDP. The blue line is the net foreign buying of U.S. securities, running at a six-month moving average of $58 billion a month. For the last year, foreigners bought $55 trillion of U.S. securities and sold $54 trillion.

Foreigners bought $679 billion of Treasuries in the year to May 2024, an amount that is close to the Treasury’s $652 billion of net new issues of notes and bonds over the same period

It’s a staggering amount. If the U.S. imposes capital controls it risks a big fall in capital flows, more difficulty funding the debt as well as possible retaliation.

Foreign borrowing. The U.S. Treasury could issue debt and immediately buy foreign currency. If that sounds far-fetched, the U.S. did precisely that in the 1960s when it issued Swiss franc denominated bonds, sold them and sent the proceeds over to the Fed. But this would require Congress to raise the debt ceiling and it may lead to sudden dollar weakness.

Lower rates. One reason for the dollar’s relative strength these days is the interest differentials. Overnight dollars yield 5.5%, with the euro at 3.8%, Japan at 0.1% and Switzerland at 1.25%. Rates would have to drop quickly and far to close the difference. You’d also need a compliant Fed to go along with lower rates.

Intervention. The Fed has no legal or official dollar policy. But the U.S. Treasury does and it could instruct the Fed to sell dollars from the Exchange Stabilization Fund, the Tresury’s emergency reserve. The fund holds $191 billion in foreign currency and special drawing rights (SDRs, a sort of reserve asset that could be converted to dollars). But $191 billion in a $7,500 billion market may not go far.

Plaza 2.0. In 1985, when the dollar was sky high, Treasury Secretary James Baker gathered his counterparts from the worlds four largest economies representing 68% of world GDP. They agreed the dollar was too strong and started a process of devaluation, sending the dollar lower by 30% over four years. Today the top 5 economies account for 56% of the world economy. At least two of them, India and China, together 20%, would not have the slightest interest in seeing their currencies appreciate by 30%.

Finally, tariffs. It’s possible that high tariffs on all imports into the U.S. would be both inflationary in the U.S. and reduce exports from China and probably slow U.S. growth. It would cheapen the currency but it’s not been done at scale before and could get messy.

That’s not a great list. Where does it leave us?

A weaker dollar may help U.S. exports but it runs counter to things like lower rates, lower taxes and tariffs. The dollar is an inherently strong currency especially when it yields more than any serious competitor. If there’s an explicit weak dollar policy, the good of cheaper export prices, may well outweigh the bad of foreign purchases of U.S. assets, expensive imports, and the added expense for U.S. companies to service foreign debt.

Our thought is that talking the dollar down may work (just don’t over do it!) especially as the rate cycle is heading down and the dollar likely to weaken in the next few years. It would be pushing on an open door.

Forcing the dollar down will be hard. It should start to ease on its own. But any move to rush to a weaker dollar will backfire.

Bottom Line

Markets had a tough week with the S&P 500 down 2.8% and the Nasdaq down 3.6% at mid-week. Some of that was earnings with Google delivering a 14% increase in revenues and earnings up 28%. But these days, earnings “beats” have to be big to impress and the stock fell 7%. It’s a $2,256 billion company and 4.5% of the S&P 500 so sentiment was hit. Tesla’s report was underwhelming. It’s 1.6% of the index and fell 19%.

We also saw weak Eurozone services and manufacturing surveys which didn’t help investor mood.

We’re not overly concerned with the market drop. Expectations are high, trading thin and investors are sitting on some very large profits especially if they overweighted the Mag 7 stocks any time in the last year. We also saw small cap stocks continue their recent outperformance over large cap stocks. Small caps are very sensitive to rates and the general direction of the economy. If rates fall, as we’d expect in September, small caps should continue to outperform.

The 10-year Treasury yield rose from 4.21% to 4.27%, which is negligible. Traders stayed on the sidelines until the next major inflation data report due Friday.

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** The FX market also uses back-to-back trades where secondary trades are made to offset the risk of a primary trade. If Bank of America sends $100 million to Costa Rica, it may split the order to spread the trade risk among several affiliates. There are also compression trades where a derivatives trade is replaced with smaller deals, but with the same total size, to spread out delivery dates.

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Art of the Week: Natalia Goncharova (1881-1962)