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May 5, 2023
No. Not unless it chooses to. Periodically, the U.S. suffers doubts of self-confidence and questions arise about the status of the U.S. and the overwhelmingly dominant role played by the U.S. dollar, both as a transactional and reserve currency.
A reserve currency is no more than a currency that governments and central banks are willing to hold in their foreign exchange reserves to finance trade. A reserve currency need only meet four requirements.
One, it is stable against other currencies, two, it is the currency of a country that holds an important share of world trade, three, there is a reasonably efficient foreign exchange market and, finally, it is convertible.
So that rules out, in order:
Few currencies meet all those requirements. And as for convertibility, the North Korean won, the Cuban peso and the Pridnestrovian Moldavian Republic’s ruble are non-convertible. If you try to convert them to dollars or euros, you’re likely to find yourself a guest in one of their reform establishments. The Chinese renminbi (more later) is only partially convertible and has a managed exchange rate.
But before we think of non-convertibility as something that happens only in strange circumstances, remember that Argentina suspended convertibility for 10 years in the 1990s, the UK did the same during World War II, and the U.S. stopped convertibility into gold and “other reserve assets” in 1971. Luckily no one asked what “other reserve assets” were but it was probably the U.S. Treasury making sure they could stop any big dollar outflows should they feel the need.
The dollar’s preeminence comes in two forms. First is as a reserve currency. This chart has been doing the rounds recently and prompted concern that the dollar is not as mighty as it was.
This shows the currency holdings of central banks with the dollar falling from 55% of all reserves in 2021 to 54% in late 2022. That’s not much of a shock except that it was around 73% in 2001 and 65% in 2017. It also shows that the absolute dollar amount fell by around $614 billion in two years. But the explanation has almost nothing to do with central banks selling dollars. It’s about moves in exchange rates and bond prices. If, say, the Bank of Japan owns $1.1 trillion of U.S. debt and U.S. rates rise, the value of those bonds falls more relative to, say, the Yen or Euro bonds it owns. This is exactly what happened in 2022. The stock of dollar reserves didn’t change but it’s price, whether as a bond price or a lower exchange rate did. So that “fall” in dollar ownership is nothing more than a repricing.
The data also shows only official reserves. It excludes dollars held by Sovereign Wealth Funds (SWF) and state banks. The top 100 SWFs invest more assets than the combined central banks reserves at around $12 trillion in 2022. These can be secretive institutions so we won’t always know exactly what they’re holding but the $1.1 trillion Norwegian Government Pension Fund, the largest SWF, owns $163 billion in U.S. bonds and another $370 billion in equities for a 45% weighting in U.S. dollar assets. The Abu Dhabi SWF, at number four, owns 60% of its assets in U.S. securities, and the Kuwait Investment Office, at number five, probably owns at least that amount.
So, if central banks and global investors are fine holding dollars, what about its second role in foreign exchange (FX) trading? Is that falling?
No. The FX market is a tough one to get your arms around. The Bank for International Settlements (BIS) thinks daily volume is $2.1 trillion. Compare that to $120 billion a day for U.S. equities and $720 billion for U.S. Treasury bills and bonds. Only around 30% of the FX volume is a simple spot trade, where someone sells euros to buy dollars to pay an invoice. More than 60% are swaps or forward transactions. Both are hedging instruments that allow two parties to protect themselves against adverse currency moves.
The U.S. dollar is one side of 88% of all trades and that number hasn’t changed in years. The biggest two-way market is between the U.S. dollar and the Euro with a 23% market share followed by the yen at 13% and sterling at 9%. Only 6% of FX volume is for the Chinese renminbi U.S. dollars cross rate. The renminbi cross rate against all other currencies, including the Euro, Yen and all the other currencies out there is less than 0.1% of all volume. The renminbi, in other words, has no standing when it comes to conducting cross border FX against anything other than the U.S. dollar.
So, if central banks, SWFs and the FX market are all fine holding and transacting dollars, what’s the problem? It really comes down to sanctions and three recent stories that made the rounds.
One, the Bangladesh government took a $12 billion loan from Russia to build a nuclear power plant. They want to pay Russia but, because of sanctions, cannot wire dollars through the SWIFT payment system. The SWIFT system controls 95% of all dollar transactions. If the Bangladesh government tried to send dollars to Moscow, they would not have got past the log in page. The Bangladesh government offered to pay in renminbi and the Chinese government obliged.
Two, Saudi Arabia agreed to price oil in and accept payment in renminbi. The amounts were not disclosed and at first sight it looks like the mighty petrodollar has a competitor in the new petroyuan. This is almost entirely a political move and nothing to do with the relative attraction of the renminbi. The Saudi Arabian riyal is pegged to the U.S. dollar and its value against the dollar hasn’t moved in over 40 years. If Saudi Arabia takes delivery in renminbi, they will immediately exchange it for U.S. dollars.
Three, China recently concluded a deal with over 30 countries to use the renminbi in bilateral trade. The list includes Brazil, Argentina, Indonesia, and Russia. Some of this is to avoid sanctions, and some of it to gain closer economic and diplomatic ties to China. But, again, the headline was a far bigger story than the amounts involved.
In the last two cases, we’d note that settling a bill in renminbi does not advance its case as an alternative reserve currency. In each case, the receiver of the renminbi will have to change it into dollars in order to use it to buy anything elsewhere in the world.
The renminbi, then, can not compete against the dollar either as a reserve or a transaction currency. It does not have an independent central bank, it does not have capital market depth, it does not have full convertibility and it does not have the trust that a full international currency must have. If I had the choice of placing my money at the Fed or the People’s Bank of China, I know which I would prefer. Many countries would probably reach the same conclusion. Over 22 countries, including Hong Kong and Saudi Arabia, peg their national currencies to the U.S. dollar and many more to a basket of currencies that include the dollar. No currency is pegged against the renminbi.
The depth and size of the U.S. dollar as an investment, as a benchmark for financial futures, as a price for all major commodities and as a reference point for foreign exchange all backed by trusted institutions, is unchallenged. There are no real alternatives. Its one weakness, when viewed from a place like Russia, is that it is subject to sanctions. But that is not a big enough reason to threaten the dollar’s dominance.
The whole saga of First Republic (FRC) ended this week as JP Morgan agreed to acquire the company. The basic problem at First Republic was that the bank grew its deposits from $34 billion in 2012 to $116 billion in 2019, and then during the pandemic when household cash was high and spending opportunities low, nearly doubled its assets again in the next two years. At its peak, it held $232 billion in deposits.
If you have that growth, you are faced with a dilemma. You have a lot of depositors who expect to be paid to keep money at your bank. They may not be too demanding if we’re all at zero rates and everyone gets zilch on their money, but they will care if rates start to rise and you’re still paying them nothing. Your other problem is to take those deposits, turn them into loans and hope those lenders pay you more than you pay your depositors. If you’re paying your depositors nothing, then almost any loan will pay you something and banking is a great business.
FRC had another trick up its sleeve. It’s based in California and, as everyone knows, California residential property is overpriced, scarce and riddled with market distortions (looking at you Prop 13). So FRC went looking for people who wanted big mortgages that were way more expensive than they could afford by normal underwriting standards and which allowed for no principal repayment requirements for long grace periods. If I’ve just described a really risky loan, then, good. Because that’s what they were and FRC said so right there on page 41 of the last 10-k report:
Our loan portfolio is concentrated in single family residential mortgage loans, including non-conforming, adjustable-rate, initial interest-only period and jumbo mortgages.”
Those types of mortgages represented some $80 billion of FRC’s total loan book of $166 billion and they earned 2.89% on those mortgages. When they couldn’t sell enough mortgages, they bought U.S. Treasuries and mortgage backed securities (MBS) and they earned about 2.14% on those. Add all their loans and securities together and they earned about 3.13%. Meanwhile, they paid out 0.86% to depositors. FRC collected the difference of 2.25% and shareholders were happy, management was happy, borrowers were happy and depositors were not quite as happy but they looked around and saw there wasn’t much choice, shrugged and stayed put. Banking was a good business.
Where were the regulators? Well, they asked and FRC sort of said, don’t worry, we’re not big or important enough and we have a very simple business model that anyone can understand. Bye. They put it as:
First Republic believes that a resolution of the Bank by the FDIC would not require the use of any extraordinary government support and would substantially mitigate the risk that the failure of the Bank could have a serious adverse impact on the financial stability of the United States. Neither the Bank nor any of its subsidiaries, are currently failing or in danger of failing…. First Republic believes that its capital and liquidity management strategy and robust capital and liquidity positions have enhanced First Republic’s financial resilience and significantly reduced the risk of the Bank’s failure.”
Just to drive the point home, they wrote to the Fed back in January and said emphatically “we’re not a large bank and we’re not an important bank”, even though they were the 14th largest bank in the country at the time. Oh, and they didn’t need to raise more capital because that was expensive and would mean an increase in leverage. For pure chutzpah, it’s quite an achievement and well worth a read if you can get past the 60 or 70 acronyms, which you may begin to suspect are put in there to confuse the average reader.
Well, ok, score one for self-confidence but over the next three months, $31 billion left the checking accounts and CDs and borrowing from the Fed went up by $90 billion. Those Fed borrowings cost around 4.8%, not the 0.86% they were paying before. Total interest expense thus went from $654 million for the whole of 2022 to $974 million in the first quarter of 2023. Oh, yes, they also had market losses of around $425 million on their MBS.
Over the last week, it was clear that FRC was on borrowed time and a rescue was put together over the weekend. The bank opened for business on Monday.
The good news in all this, aside from the fact that depositors were protected, was that equity and bond shareholders lost money. This is how it should be. If you lend money to a bank, by buying a bond, or you own part of a bank, by buying its stock, and management, well, mismanages and asks for a bailout, creditors and owners should take it face on. This is what happened to bond holders.
I know. It’s painful. It was an A- credit a few months ago and now it’s in default. The preferred stock traded at $20 in January. It’s now $1.63. Finally, the equity took the company’s value from around $38 billion a few months ago to $560 million.
This is progress. During the great financial crisis, many bondholders were protected when banks like Wachovia, Washington Mutual, and Merrill Lynch were bailed out by various government entities and placed into the operations of Wells Fargo, JP Morgan and Bank of America. The point of many of the post-GFC reforms was to ensure that stock and bond holders absorb the risk of failure and thus lower the cost to the FDIC and the public. This was meant to happen and, to us, represents progress in the way banks are bailed out.
In 2008, various programs like the TARP (which purchased banks’ bad assets) and bailouts for Fannie Mae and Freddie Mac, the government spent around $634 billion. Eventually much of that was repaid in the form of interest received, fees and stock repurchases. The net profit to the government was around $109 billion but it took many years to recover the expense. This time the cost to the FDIC has been around $22 billion of which all but $3.3 billion will be recovered by increasing FDIC premiums for banks in coming years. We’d note that the FDIC insurance fund stood at $128 billion at the end of 2022, and increases at the rate of around $2.7 billion a quarter. All the monies are collected by charging banks insurance premiums. The cost to taxpayers is zero.
Bank problems are nail biting affairs. As one commentator put it, “it’s completely irrational to start a bank run. But if somebody else starts it, it’s completely rational to participate in it.” First Republic seemed fine until suddenly it wasn’t. Fortunately, depositors did not lose money but anyone who owned or lent to the bank, probably did. We’d note that the regulators moved quickly and found it a home and at almost zero cost to taxpayers. That seems like progress from 2008.
The Fed raised rates this week. Just over a year ago the Fed funds rate was 0.25%. It’s now 5.25%. The Fed has only moved that fast once before, when, between August 1980 and January 1981 it raised rates from 9% to 19%. That was a shock. Rates doubled in six months. But 2022 and 2023 deserve their own place in the record book. The Fed has raised rates ten times in successive meetings and the fed funds rate has risen by a factor of five. For someone paying back a $500,000 30-year mortgage, monthly payments would have risen from $1,900 a month to $3,400, an 80% increase.
One pushback against the rate increases is that real rates are still low. After all, headline inflation is around 5% and the fed funds rate only just above it. But inflation is a backward-looking indicator. When we look at inflation expectations, we see a different picture.
The blue line is simply the fed funds rate less headline inflation. The green line is the fed funds rate less expected inflation. It reads as 0.93% but the data is stale and should show the latest Fed Funds and University of Michigan data. It should be 5.25% less the inflation expectation of 2.9% rate and so should read 2.35%.
That number is higher than it has been for 16 years. Normally, inflation expectations are lower than current or realized inflation, as shown by the green line consistently below the blue. But that’s no longer the case. Borrowers now see the expected real cost of debt as high and getting higher if rates stay where they are, and inflation falls.
The traditional prime rate for businesses is the fed funds rate plus 3%. That means it’s now 8.25% and, for a less than prime borrower, it could exceed 10%. For a business owner financing inventory or working capital, things just got very expensive.
So, while real rates may still look low to the Fed, to a borrower looking five years out they look very high. That will probably start to show up in the economy in the months ahead.
Again, this is our list of things we’re watching:
The state of play is that the House Republicans passed the “Limit, Save, Grow Act” by the slimmest of margins. It eliminates a lot of clean energy tax breaks from the Inflation Reduction Act of 2022, introduces work requirements for various programs, nullifies Student Loan forgiveness programs, repeals all “market distorting green tax credits,” eliminates Section 10301 of Public Law (it’s the bit about improving tax compliance…all a bit depressing, don’t bother to read it) and a bunch of other stuff. In return, it increases the debt limit by $1.5 trillion or until March 2024. It’s not both/and, it’s either/or.
The White House and Senate Dems don’t like it. Meanwhile, Treasury Secretary Janet Yellen wrote this to the House Speaker Kevin McCarthy:
The new news is that the debt ceiling may be broached as early as June 1st, some two weeks before the last “X-Date” she gave back in January. That’s because of this… Taxes and Deposits: Fiscal Year – May 3, 2023:
This shows all income, corporate, capital gains, and excise taxes, fees, duties, and the Fed’s remittances to the Treasury. They’re down by $182 billion over 2022, even though (nominal) GDP is 7% and $2 trillion higher than this time last year. It’s mostly to do with lower capital gains taxes and quicker response time from the IRS. The IRS hired 5,000 new customer service representatives in late 2022 out of a workforce of 79,000. That means quicker response times and fewer late filings. Janet Yellen is basically pointing out that late tax filings are not going to happen on the same scale as prior years, and revenue is down, so please do something.
On the financial side, U.S. credit default swap (CDS) prices fell marginally but are still 162bps and 140bps above what they were in January. If you buy a 1-year CDS your yield drops from 4.58% to 2.96%. That’s a high insurance price but, as we’ve mentioned before, those are screen prices not real prices and the dollar amounts traded are negligible…so, ok.
As we also mentioned last week, the risk premium around short-term bills remains extraordinarily elevated. A bill maturing a few weeks from now yields 3.75% while one in August yields 5.1% After that yields drop to around 4.4%, which is where the market thinks the fed funds rate will be around in November.
At this point, we see seven (and seven is the key number) possible outcomes:
So, yes, there’s more angst out there than there was a month ago. But one of those options will happen. We’re concerned but not alarmed. It will be messy though and expect lots of doom-scrolling.
Those looking for good signs in the tight labor market got some good news this week. The number of job openings fell and are down 2.4 million from a year ago. Layoffs and new claims went up. The all-important NFIB report on hiring showed only 17% of small businesses plan to hire more, down from 25% a few months ago.
The Fed raised rates, probably for the last time for a while. The 10-Year Treasury rallied to 3.35%, its second lowest level in six months. A 7–10-year Treasury portfolio has returned 5.6% this year and a broad bond index of corporates, Treasuries and mortgage backed securities has returned 4.2%.
The S&P 500 was mixed, closing up at down 0.5% ahead of the jobs report on Friday (our deadline is Thursday midday Pacific Time so occasionally you’ll see stuff which gets a “wait, what…. what data is he reading?” reaction). We’ve liked what we’ve seen coming from the earnings season. Around 80% of companies have reported an upside earnings or sales surprise. The next few weeks will be about the debt ceiling and seeing how many smaller banks call it a day and go looking for buyers.
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Art: Zoey Frank (b. 1987)
Please read important disclosures here.
Christian is a Partner in the Mill Valley office. Prior to joining Cerity Partners, Christian was Chief Investment Officer for Brouwer & Janachowski. He oversaw...
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