Continuing from Part 3, if the FED reverses back to quantitative easing and rate cuts, then it is definitely bearish for the dollar with interest rate differentials in mind. The interesting thing is there is a lot more to the bearish case for the dollar.
Let’s start with the fiscal side of the dollar via government debt. The CBO (Congressional Budget Office) has a projection of what the deficits will be through 2028. The first issue with this is that this projection assumes that there will be no recession over these 10 years. With this in mind, one might ask why the US deficit is soaring prior to even having a recession? This comes down to weak politics and soaring past promises. If we have a recession, then one can safely assume that deficits will balloon even more as we can use a proxy for such a move in 2008. What I like about this chart is it proposes a key question. What happens if the deficits balloon and we have interest rates that are not historically low anymore? As you can see below, should interests rise, the deficit will rise even more.
What might cause interest rates to rise other than the ballooning supply of debt via growing deficits as presented earlier?
Treasuries used to be primarily sold to foreigners, but now our debt is funded primarily domestically. I believe this is due to the fact that the rest of the world recently has been looking to diversify against US investments, which I will get into reasons why later. Anyways, if we assume that at current interest rates foreigners have minimal demand for US treasuries, then these treasuries must be bought by the domestic citizen. Now, the question is if the economy slows in the US, will US citizens be able to fund higher US deficits? Bottomline, it is unlikely that the domestic citizen will be able to fund the US debt indefinitely, so rates will have to rise to bring foreign demand back in or increase domestic demand. My opinion is long term in nature. I do see the probability for lower rates during a recession via the flight to “safety” assets and assumed FED cuts to come.
On to the next problem. Most US debt is short duration, which means the national debt is very susceptible to rising interest rates. Even if interest rates do not rise, it is important to note that rates are not at 0% like they once were. Any debt that needs to be rolled over today that had been previously locked in at rates between 2009-2017, will still make an impact on rising interest payments and increasing deficits.
The elephant in the room is inflation.
Should inflation run hot, the FED’s corner will be as small as ever. In the event that the stock market is crashing and the economy is deteriorating, the FED would love to revert to the old playbook of cutting rates. The issue is that if inflation is running high, then our bond interest rates need to be higher to compensate lenders for inflation. The FED’s hand will then be forced between asset prices or inflation. The more politically palatable choice is likely to attempt to re-boost asset prices by cutting rates. Unfortunately, this should exacerbate the inflation. For starters if we cut rates, then those cuts and all future rate hikes will have to be repriced in the market. This is dollar bearish. For a country that imports most of our real goods, this will not bode well. This is due to the fact that the US consumer will be bidding for the same goods as before, but with a weaker dollar. This will make the prices of goods in dollar terms rise.
A picture of ballooning deficits coupled with inflation risks has now been presented. Let’s move on with an understanding of the significance of the current dollar monopoly on international trade.
A reserve currency is a large quantity of currency maintained by central banks and other major financial institutions. The purpose is to prepare for investments, transactions and international debt obligations, or to influence the domestic exchange rate.
The USD has recently made up 60-80% of global reserves by major financial institutions. All this really means is that most global savings are held in dollars.
The reasons that other countries use US dollars for reserves are tradition with the dollar being the last currency redeemable in gold, relative historical fiscal stability, strong rule of law, the fact that much of the current global debt is denominated in dollars, and the fact that essentially all oil is traded in US dollars. As of July 2018, the Yuan oil futures had a market share of 14.4%, compared with 28.9% for the Brent futures, and 56.7% for WTI futures. This means that in order to bid for about 80% of the oil in the world, one must first possess dollars. This I believe to be the main artificial driver of the dollar.
I view the dollar theoretically as possessing an artificial bid. This is largely due to other nations needing to have dollars to pay off dollar denominated debt and to purchase oil. The question to answer is what would cause this artificial bid to dissipate? Below is a simple diagram that demonstrates a graphical representation of the artificial bid. As one can see the removal or loss of this bid will revert the dollar to normal demand. It is nearly impossible to quantify the power of the artificial bid, especially since it is not likely that an event will occur that will take away all of it in a clear cut way to provide for hindsight.
The US understands its monopoly and has used it to its geopolitical advantage. In the event that countries do not follow the US global rule of law, then the US will punish them in the field of financial warfare. This includes the use of Fedwire and SWIFT.
Fedwire is one way for international entities to transact. Upon study it becomes understood that the US Government/FED has the ability to create chokeholds in the system in the event that they want to block out certain countries or businesses from using the service. This system is only for the use of dollars, which the US government believes they have total oversight and authority into every transaction no matter where it occurs as long as it is denominated in dollars. This type of issue is where you hear the US sanctioning foreign businesses or countries because the US deems some act of business to be wrong for whatever reason it may be.
The more notable international payment program is SWIFT. The USD continues to hold the greatest market share of use within SWIFT and has exercised that power. The US has essentially declared itself the defacto administrator of global trade and in a way, and has self-appointed itself the authority to decide what is right and wrong in trade. Whatever your view may be, I just ask you to put yourself in other nations’ shoes. Would you like being told what you can or cannot do?
So am I speaking nonsense or are the pieces starting to become visible to the public? Earlier I presented a chart showing that US debt has shifted funding from international to domestic. This means foreigners are less eager to lend us money. Also, around the same time, US SWIFT market share began to decelerate.
I also had mentioned the Yuan oil contract. What I did not mention is that it was launched in March of 2018. A notable takeaway that demonstrates the occurring change is that in 6 months, the Yuan futures have picked up the market share that it took the Brent futures 14 years to pick up. There is clearly international interest around the world.
I view the battle as of now as the US vs. China and Russia. The reason for this is that the rest of the pieces of the chess match are either too insignificant in solidarity or still technically can be swayed to either side of what the history books will call Cold War 2. With this in mind, let’s look at some strategic moves that have taken place by the main players. Please see below that both Russia and China have been selling US Treasuries and have been buying gold. This is a trend that is not unique to these two countries as many central banks around the world have been stocking up on gold in recent years.
Let’s play this scenario a little further out. What happens when the domestic buyer can no longer support the exploding debt? The answer is either debt restructuring, default, or debt monetization. Since debt is mostly held by domestic citizens, the government will unlikely default on its own people. Therefore, debt monetization is the most likely choice for future policy makers. This is the game over scenario for the USD.
If one day the FED has to resort to a form of QE4ever in order to contain bond yields low enough to keep interest payments on the national debt tame and to support asset prices and capital investment, then the dollar will tank. This type of policy will force the rest of the world to not be able to hold USD in reserve due to intense fiscal irresponsibility dragging down the dollars value.