Eliud Kipchoge, the only man to ever run a marathon in under two hours, is in town for next week’s Boston Marathon. In the runup to the race, reporters will no doubt ask him about whether he is worried about any particular competitor. He will predictably reply that he is not—but that he has to focus on his own fitness and his own decisions in running the race. As with all individual sports, the keys to success or failure lies largely in the athlete’s own hands.
In recent weeks, many investors and financial professionals have asked worried questions about the dollar, whether China will put an end to its long era of dominance and what that could mean for investing. While the concern is understandable, it seems overblown, at least at this stage. That being said, the greatest threat to the dollar lies not the behavior of our competitors but in our own behavior and, most notably, in the current reckless standoff over the debt ceiling.
Rumbles Of Concern
The wave of concern about the dollar is understandable. There has been a steady drip of news over the last few weeks portraying a more assertive China in global affairs and increased efforts by China to boost the use of the yuan in global transactions. These headlines include President Xi’s state visit to Moscow last month, Chinese-brokered peace talks between Saudi Arabia and Iran, and the surprise announcement of a cut in oil production by the OPEC+ group, led by Saudi Arabia and Russia, much to the displeasure of the U.S. government.
In addition, at the end of March, China and Brazil announced a trade agreement by which they would settle trade transactions in yuan using China’s Cross-Border Interbank Payment system, bypassing the dollar-dominated SWIFT system. This deal, which follows similar arrangements between China and Iran, Pakistan and Russia, is part a broader effort by China to increase global trading in yuan. However, it also has some appeal for other countries who are concerned that the SWIFT system can be used as an instrument of U.S. foreign policy as has recently been the case with both Iran and Russia.
Moreover, all of this has occurred against a backdrop of a gradual decline in the dollar. Since peaking last September, the trade-weighted dollar index has now fallen by over 10%, a trend that is undoubtedly feeding some investor concerns.
The Advantages And Disadvantages Of Dollar Dominance
Before considering the threats to the dollar, it’s important to understand how it has achieved its current status. Its ascendency, for the most part reflected the growing economic power of the United States in the 20th century in contrast to the declining power of the United Kingdom. After World War II, however, this dominance was cemented by the Bretton Woods system of international institutions and the confidence that global investors have generally felt about U.S. political stability and the rule of law. Moreover, despite recent headlines and many predictions of the dollar’s demise over the years, it maintains its preeminent global position today, accounting for half of international trade transaction invoicing and 60% of global central bank reserves as well as being involved in almost 90% of all foreign exchange transactions (Source: “Triennial Central Bank Survey”, Bank of International Settlements, April 2022).
While many Americans may feel a certain national pride in the global role played by the dollar, this dominance brings with it some important advantages and disadvantages.
On the positive side, the dollar’s position has allowed both the U.S. government and U.S. firms to borrow cheaply and with less uncertainty from around the world by issuing dollar- denominated debt. Unlike the situation in many emerging market countries, U.S. borrowers using dollar-denominated debt do not have to worry that a sudden change in the exchange rate will increase their liabilities and investors have greater certainty over the value of the assets they hold.
In addition, the U.S. benefits from the willingness of foreign citizens to hold U.S. banknotes. At the start of April, total U.S. currency in circulation amounted to over $2.3 trillion, or almost $7,000 for every man, woman and child in the country. The Federal Reserve estimates that roughly half of this cash is actually held outside the United States to facilitate transactions in countries with unstable financial systems or runaway inflation. The willingness of foreigners to hold U.S. banknotes amounts to a large, interest-free, loan to the Federal Reserve and ultimately to U.S. taxpayers.
The dollar’s dominance also gives the U.S. economic power, making it difficult for international banks or companies to do business with countries upon which the U.S. has imposed sanctions.
However, there is also a downside to the dollar’s importance. The most obvious problem is that the global appetite for dollars over the years has maintained the exchange rate at a too-high level. Indeed, the U.S. has now run a current account trade deficit for 31 straight years—a deficit that has averaged 3.5% of GDP this century and was 3.9% of GDP last year. This has simultaneously cost the country millions of manufacturing jobs and increased our foreign indebtedness and promises to continue to do so for years to come.
The Outlook For The Dollar
The most likely path for the dollar from here is one of slow decline. Last week’s employment report showed a slowdown in both job growth and year-over-year wage growth. This week’s numbers should reinforce this narrative, as we expect to see a decline in both month-over-month retail sales and year-over-year CPI inflation. Meanwhile last week’s PMI data generally showed an acceleration in the global economy. We expect that the next few months will also see a less hawkish stance from the Federal Reserve than other central banks which could facilitate a further slow dollar decline.
That being said, we do not foresee any sharp change in the dollar’s role in global trade or central bank reserves or general international usage. Global investors still have a very healthy demand for U.S. stocks and bonds. The transparency of U.S. institutions and the rule of law still enhance the attractiveness of dollar-denominated deposits. Moreover, as with many technologies, there is a certain advantage retained by the market leader. If the U.S. dollar is by far the most generally accepted currency in the world, then it is hard for most individuals or companies that need to hold or trade in a foreign currency to opt for the second-best choice.
Investors should, however, be aware of the risks posed to the dollar by the current standoff in Washington concerning the debt ceiling. As the tax season hits its crescendo this month, the Treasury Department will get a better sense of how many more months or weeks the U.S. can go without either raising the debt ceiling or defaulting on government obligations. While both sides privately assure investors that there is no danger of a default, both seem willing to push the issue down to the wire for political advantage.
Any miscalculation in this regard could be catastrophic, undermining faith in the credit of the U.S. federal government that has been accumulated since the days of Alexander Hamilton. If such an event were to occur, it would likely add a permanent risk premium to U.S. government bonds and precipitate a much sharper decline in the dollar. It would also add a powerful argument to the arsenal of those promoting other global currencies who could then point to the U.S. democratic process as a source of economic vulnerability rather than economic strength.
If, however, the better angels of our political process prevail, while the dollar’s value may slowly fall to a more appropriate level, its dominance of the global financial landscape should be sustained, removing one risk from the current list of investor worries.
David Kelly is chief global strategist for J.P. Morgan Asset Management.