The U.S. Dollar, as the world’s major reserve currency, has recently faced speculation about its decline and potential loss of status due to “de-dollarization.” This refers to the movement away from using the U.S. dollar as the primary currency for global trade and investment. Adding fuel to the fire, China is starting to use the Chinese yuan in commodity trades with select trading partners, and Brazil and Argentina are considering a common currency. However, while there may be a trend towards diversification of currencies in global transactions, the argument that the dollar is on the verge of losing its reserve currency status is likely overstated.
One of the main reasons for the speculation is the decline of the U.S. dollar’s value over the past six months. According to various indices, it has fallen by about 8–10 percent in both real and nominal terms since late last year. However, the decline over the last six months came after a period of appreciation for the dollar, which had been propelled higher by relatively high U.S. interest rates compared to other major countries, strong capital inflows, and its status as a “safe haven” currency. In fact, the dollar’s value had increased 1.4 times from its 2011 low to its peak in 2022, adjusted for inflation.
More recently, the dollar’s relative underperformance during the recent banking crisis added to the speculation that the dollar might be losing its status as a “safe haven” currency during times of financial stress. Given the spike in volatility and systemic risk concerns arising from bank stress, many investors were puzzled by the dollar’s underperformance relative to foreign currencies. As the banking crisis unfolded, markets quickly shifted focus from the possibility of more Fed hikes and a 6% terminal interest rate to the prospect of tighter credit, increased risk of recession, and the likelihood of Fed interest “cuts” within the coming months. We believe that rather than furthering the argument for de-dollarization, the recent underperformance of the dollar was due to the rapid downshift in forward interest rate expectations.
Further, the recent decline in the dollar’s value does not necessarily indicate a major shift away from the dollar as the world’s reserve currency. While it is true that the dollar’s share of global reserves has declined gradually over the past 20 years as central banks diversified their holdings, the dollar still represents about 60% of global reserves. This is only a modest decline from 67% two decades ago. Moreover, allocations of reserves to other currencies such as the British pound and Canadian dollar have gained only incrementally. A reserve currency needs to be freely convertible and have deep, liquid bond markets to be considered “safe” for foreign central banks to hold. The U.S. market for Treasury securities fits that role.
One of the reasons why the dollar remains dominant is the size and openness of the U.S. market. While other major countries’ markets may have some of the same qualities, they have limitations that prevent them from becoming a viable alternative to the dollar. For example, Europe’s bond markets are more fragmented than the U.S. market, although a movement towards Euro-denominated sovereign debt issuance could potentially strengthen the Euro’s position. Japan’s bond market is closely controlled by its central bank, which owns the majority of its government debt. China, on the other hand, has capital controls in place, and its currency is not freely convertible. Relaxing capital controls would mean relinquishing control over investment flows, which could ignite inflation and expose China’s yuan to decline if domestic investors moved their money elsewhere.
It is also important to note that recent non-dollar transactions in yuan, which have raised alarm about the potential decline of the dollar, accounted for less than 2% of global trade in 2022. This indicates that the impact of these transactions on the demand for dollars is relatively benign.
Furthermore, there is no evidence that major foreign holders of our currency are poised to suddenly shift away from U.S. dollars. Despite the recent decline in the dollar’s value, there are few indications that foreign central banks are actively divesting from the dollar in a significant way. While there may be some countries exploring alternatives like the yuan or considering a common currency, these efforts are in their early stages and have not posed a significant threat to the dollar’s status as the world’s reserve currency.
We think current concerns over the death of the dollar as the world’s reserve currency are largely overstated. As part of our diversification strategy, we actively invest in multinational and foreign securities to hedge against declines in the U.S. dollar. We will continue to remain vigilant of any possible changes affecting our thesis and make prompt changes to our managed portfolios if needed.
Market Commentary: April 2023 – Is the Dollar Doomed?
Is the Dollar Doomed?
April 20, 2023
By Robert F. Taylor, CFA
The U.S. Dollar, as the world’s major reserve currency, has recently faced speculation about its decline and potential loss of status due to “de-dollarization.” This refers to the movement away from using the U.S. dollar as the primary currency for global trade and investment. Adding fuel to the fire, China is starting to use the Chinese yuan in commodity trades with select trading partners, and Brazil and Argentina are considering a common currency. However, while there may be a trend towards diversification of currencies in global transactions, the argument that the dollar is on the verge of losing its reserve currency status is likely overstated.
One of the main reasons for the speculation is the decline of the U.S. dollar’s value over the past six months. According to various indices, it has fallen by about 8–10 percent in both real and nominal terms since late last year. However, the decline over the last six months came after a period of appreciation for the dollar, which had been propelled higher by relatively high U.S. interest rates compared to other major countries, strong capital inflows, and its status as a “safe haven” currency. In fact, the dollar’s value had increased 1.4 times from its 2011 low to its peak in 2022, adjusted for inflation.
More recently, the dollar’s relative underperformance during the recent banking crisis added to the speculation that the dollar might be losing its status as a “safe haven” currency during times of financial stress. Given the spike in volatility and systemic risk concerns arising from bank stress, many investors were puzzled by the dollar’s underperformance relative to foreign currencies. As the banking crisis unfolded, markets quickly shifted focus from the possibility of more Fed hikes and a 6% terminal interest rate to the prospect of tighter credit, increased risk of recession, and the likelihood of Fed interest “cuts” within the coming months. We believe that rather than furthering the argument for de-dollarization, the recent underperformance of the dollar was due to the rapid downshift in forward interest rate expectations.
Further, the recent decline in the dollar’s value does not necessarily indicate a major shift away from the dollar as the world’s reserve currency. While it is true that the dollar’s share of global reserves has declined gradually over the past 20 years as central banks diversified their holdings, the dollar still represents about 60% of global reserves. This is only a modest decline from 67% two decades ago. Moreover, allocations of reserves to other currencies such as the British pound and Canadian dollar have gained only incrementally. A reserve currency needs to be freely convertible and have deep, liquid bond markets to be considered “safe” for foreign central banks to hold. The U.S. market for Treasury securities fits that role.
One of the reasons why the dollar remains dominant is the size and openness of the U.S. market. While other major countries’ markets may have some of the same qualities, they have limitations that prevent them from becoming a viable alternative to the dollar. For example, Europe’s bond markets are more fragmented than the U.S. market, although a movement towards Euro-denominated sovereign debt issuance could potentially strengthen the Euro’s position. Japan’s bond market is closely controlled by its central bank, which owns the majority of its government debt. China, on the other hand, has capital controls in place, and its currency is not freely convertible. Relaxing capital controls would mean relinquishing control over investment flows, which could ignite inflation and expose China’s yuan to decline if domestic investors moved their money elsewhere.
It is also important to note that recent non-dollar transactions in yuan, which have raised alarm about the potential decline of the dollar, accounted for less than 2% of global trade in 2022. This indicates that the impact of these transactions on the demand for dollars is relatively benign.
Furthermore, there is no evidence that major foreign holders of our currency are poised to suddenly shift away from U.S. dollars. Despite the recent decline in the dollar’s value, there are few indications that foreign central banks are actively divesting from the dollar in a significant way. While there may be some countries exploring alternatives like the yuan or considering a common currency, these efforts are in their early stages and have not posed a significant threat to the dollar’s status as the world’s reserve currency.
We think current concerns over the death of the dollar as the world’s reserve currency are largely overstated. As part of our diversification strategy, we actively invest in multinational and foreign securities to hedge against declines in the U.S. dollar. We will continue to remain vigilant of any possible changes affecting our thesis and make prompt changes to our managed portfolios if needed.
Shannon DermodyTEST