Introduction
One of the stereotypical memes in investing & trading is the narrative about the death of the dollar.
Certain people have ironically made substantial amount of dollars from writing about the supposed decline of the dollar in fact.
This has been largely stoked by libertarians and the left and so-called “professional economists” through sheer idealism (and sometimes outright hatred) regarding the USA’s currency and it’s position in the international financial system. Indeed, the mainstream media tends to buy-into this narrative and repeat it and there are of course lots of popular memes and tropes about money printing and hyperinflation and so on and so forth.
Realistically, it’s also sort-of easy to see why these are easy ideas to accept considering everything we’ve seen economically over the past decade including the actions of the Federal Reserve and the US central government.
However, it is quite easy to disprove a lot of these narratives through a simple examination of some statistics and facts regarding the dollar and the international financial system.
There is also quite a knowledge-gap and a certain amount of ignorance around the role of the dollar and the international monetary system. Much of which is stoked deliberately by certain actors for their own benefit and we’ll try to address some of that within this article.
The bottom-line, is that despite a lot of bearish sentiment around the US dollar in the markets, underneath the miscomprehension about certain aspects of the financial system, the dollars’ technical and fundamentals are actually pretty good.
Additionally, this is one reason why an short-assets bias makes sense in the long term, because the outline we’re going to examine in this article actually spells chaos for most financial markets worldwide.
Recent Dollar Performance
On the right, we can see a chart of DXY Futures.
The DXY (The Dollar Index) is one of the most popular ways to benchmark relative dollar strength (though, as we will see in this article, it is not without it’s own issues).
As we can see, since 2020, the US dollar has pulled back significantly (by around 10%) and of course this has been feeding the usual stereotypical narratives of dollar collapse, the demise of the dollar hyperinflation, etc. etc. from the media and popular political commentators and so forth.
In fact, if we take a look at the same chart with a much broader perspective, we can see that over the long run, the dollar is still massively stronger than it was just 7 years ago.
Despite the substantial pullback during the COVID-19 pandemic, it is still around 17% stronger than it was just 8 years ago.
This began with a rally around the year 2014 and actually, despite the substantial pullbacks we have seen along the way, the dollar is still ultimately much stronger than it was in 2014.
If we widen our view even more, we can see that despite what people think, the dollar downturn ended with the onset of the Great Financial Crisis and the modern bull run actually began around the same time in 2008.
This means the dollar has gained over 25% in just over 12 years and despite pullbacks and corrections, is still in a major uptrend sitting right on it’s major support line.
This flies in the face of the typical theories we hear and read about suggesting the dollar is collapsing, but the truth is, that the dollar is probably gaining a minimum of about 2% per annum on average even at the bottom of the uptrend.
Additionally, as we can see, there have been plenty of short term moves higher as the dollar proceeds along this primary trend and this suggests that another 10% – 20% appreciation (if if just a temporary one) is more than plausible from a technical perspective over the next couple of years..
As such, the recent dollar downturn can be viewed in context of a much broader set of moves higher which are averaging 2% gains per annum over a decade and a half (which, I might point out, has often outpaced the official numbers on CPI inflation).
After making a very similar set of moves during 2020 to the downmove made in 2018 and with the USD Index sitting right upon it’s primary 15 year trendline, it’s entirely reasonable to expect another repeat of the 2018-2019 burst of strength from a technical perspective.
In fact the USD Index has already gained about 4.15% already during the first quarter of this year alone (which will almost certainly outpace the final CPI inflation figures for the year).
With a similar set of moves to the 2018 rally being apparent on the longer term chart along with the fact of the DXY index sitting right on it’s major support line (and already showing a strong bounce, it is my expectation that ultimately, over the course of 2021/2022 we will see a renewed wave of dollar strength making it’s presence known in international markets.
This has absolutely enormous implications for the international financial system and the world economy and we’ll go over a lot of the reasoning and evidence for this within this article.
Why The Dollar Matters
There are many reasons why dollar strength is a fundamentally important factor to the world economy.
In fact, the world economy really isn’t built to tolerate a strong dollar and there are actually lots of issues which can arise as a result of the dollar being too strong for the underlying financial system and it’s fundamentals.
We’re going to look over a few of these in this article.
Recent Asset Strength Is Often More A Case Of Dollar Weakness
As we can see from the chart of AAPL (Apple Inc.) stock prices on the right, there is a near perfect inverse correlation between the DXY Dollar Index and the price of Apple stocks.
As such, we can conclude from this that dollar strength is already having a huge impact upon equity valuations.
This is because ultimately, fluctuations in the relative strength & purchasing power of the dollar are causing fluctuations in the prices of stocks and in fact, all assets on the market.
Another example of this can be seen in commodities markets such as Oil.
Oil is particularly sensitive to dollar strength due to the factor of the petrodollar which forms part of the international oil market system (as well as the fact that the US is the primary consumer of oil products worldwide)..
However, as we can see on our chart to the left, even the British oil market, Brent Oil, is displaying essentially the same inverse correlation to dollar strength movements which United States equities are.
In fact, whether on iShares Silver Fund (SLV) or Bitcoin futures (as shown on the charts below), the same signatures of dollar strength fluctuations which have ultimately driven asset prices exist all over the marketplace at exactly the same points in time.
As such, it’s obvious that dollar strength (or rather, dollar weakness) has been the primary driver of asset performance over the last 3 years.
The obvious question here is… what happens to asset prices if this weakness reverses?
The Global Dollar-Debt Timebomb
The issue of debt is also fundamental ongoing weakness in the monetary and financial system.
What tends to be overlooked in this respect is a factor which I call “cross-forex contagion” and this is primarily a factor relating to how dollar strength will cause issues in the financial markets due to how their debts are structured.
That is to say, that lots of sovereign nations and corporate entities are vulnerable to dollar strength because they are borrowing enormous amounts of money which are only payable in dollars rather than their own currencies.
This is because the central governments and corporate sectors of most nations, although they do not use the dollar as their national currency (and therefore have zero control over it) still borrow substantial amounts of money in dollars over the course of raising money to finance their own spending habits (which are often substantial).
This means that, when it comes to servicing and paying-back this debt, they have to actively buy dollars (using their separate national currency) purely to be able to service the principle and interest on their debts.
Naturally, if the dollar appreciates in value against their national currencies, the costs of servicing their debts can spiral out of control.
We should not underestimate the scope of this problem.
The Bank For International Settlements (BIS) published a paper in 2018 exposing the gravity of this issue [1].
According to the BIS, the dollar-denominated debt of non-banks outside the USA stood at $12.652 trillion in 2020, of which, non-banks in emerging market economies accounted for $3.7 trillion.
This figure is more than double the level measured in 2010.
The BIS GLI [2] also shows that this dollar-denominated-debt is experiencing year-on-year growth of at least 5% per annum.
If we look at the chart to the right, we can see that over $1trillion of this figure is concentrated within the BRICS emerging markets leaders group with projections that this debt is set to accelerate in the next couple of years.
We must bear in mind, that this is ultimately based on 2020 FOREX prices.
That is to say, this total was measured at a point in time when the dollar was relatively weak.
Additionally, these emerging market nations are export-heavy which means they have an incentive to keep their currencies weak against the dollar.
As such, these nations which are relying on dollar-debt to boost their economies may find themselves on the wrong-end of the trade if the dollar meets our expectations and rallies.
Indeed as we can see from the chart below, dollar spikes have a history of coinciding with emerging market defaults.
Why The Dollar Will Rally
Firstly, we tend tend to assume that due to the lurid tales of money printing and quantitative easing and stimulus and so forth, that there must be an enormous supply of dollars in the world.
Indeed we are constantly fed panic-stories about hyperinflation and the degradation of national currencies almost 24/7 via self-appointed internet-experts and ironically, even many professional academics buy-into these ideas as well as do the international media.
However, most of these scare-stories are actually false and based largely on events which happened in other nations which don’t apply in modern western contexts for reasons which we will explore later in this article.
We must also remember that ultimately, the dollar is a global currency and, although it’s easy to see why people might think that the dollar and it’s supply & demand dynamics are confined to the boundaries of the United States, this isn’t actually accurate and we have to think about the supply of dollars in relation to it’s role as the global reserve currency.
As such, what we need to actually do in this piece to properly assess the US dollar is:
- Break-down The Demonstrable Global Supply Of The USD
- Examine The Relative Level Of Demand For It
To start with, as we can see to the right, the actual amount of M2 (which represents the most liquid forms of money in the United States) which can be quantified as being just below $20trillion dollars.
This is the total supply of what we will refer to as the “domestic dollar” for the purposes of this article (for reasons which we will shortly be making clear) and, although use of M2 as a measure of dollar liquidity is problematic (again, for reasons we will examine within this article), for now we will just focus on the raw numbers as published by the Federal Reserve.
We must also examine the role of the offshore bank-led Eurodollar system here.
For those who are not familiar with this term, then “Eurodollars” are basically dollars which are issued by the international financial system outside of the United States.
It’s accurate to think of them as essentially an “Offshore” version of the regular USD and the reason this is important is because we cannot.easily quantify how many Eurodollars are actually in existence because they are issued and exist outside of the Federal Reserves’ regulatory orbit.
In 2016, the size of the Eurodollar market was estimated by Nedbank to be around $13.833 trillion.
This represents massive growth upon estimates made in 1986 by JP Morgan when the Eurodollar market was quantified as representing just $1.68trillion dollars.and as we can see to the chart to the right, Eurodollar Futures (derivatives) volume has exploded over the past 2 decades.
Indeed most international financing deals are made using Eurodollars and the Eurodollar makes a significant contribution to the global dollar market capitalisation and yet, it exists largely outside of the Federal Reserves’ regulatory orbit.
Putting the two factors of the “onshore dollar” and the “offshore dollar (the eurodollar)” together, the total quantifiable supply of the dollar is around $33.8trillion.
Indeed this figure is far more generous than many mainstream estimates which focus solely on the domestic dollar. In truth however, we must absolutely not ignore the role of the Eurodollar in international finance.
Dollar Strength Is Ultimately Being Driven By Demand Produced By Dollar Debt
One of the primary sources of demand for dollars which has supported the dollar rally since the great financial crisis is the explosion of dollar-denominated debt.
As we all know, debt is at record all-time highs (and we’ll look over some of the numbers). However, the really important factor, is that the overwhelming vast majority of the debt in the world is issued in dollars.
US government debt alone, is now about $26,700,000,000,000 ($26trillion) – all of which must be serviced in dollars..
Alongside this, there is another $14.2trillion owed by private US citizens in the form of mortgages, car loans, credit card balances, etc. etc. again, all of which must be serviced with dollars.
Meanwhile, according to the Bank for International Settlements, as we can see in the chart to the left, international dollar debt (Excluding banks) held in non-US nations is approximately $12trillion and growing.
Again, because this debt is denominated in dollars, it must be serviced in dollars meaning ultimately. that international debtor-nations must buy dollars in order to pay their debts..
Indeed these figures themselves are likely to be far too low as the BIS themselves reported within a Telegraph article in 2017 that an extra $15trillion of dollar denominated debt are actively being concealed offshore in dollar swaps and other derivatives.
This adds-up to a preliminary total of $61,900,000,000,000 ($61.9trillion) of dollar debt in the world according to the two sets of BIS figures for both onshore and offshore dollar debt and we must remember that this still excludes many sources of “hidden” dollar-debt such as the interbank system and the hidden derivatives which the Telegraph discovered.
We can also make an assumption here that most of this debt will be generating at least 2-4% interest on average per annum (in reality, a large percentage of it will be yielding much higher rates due to the issue of sub-prime lending and so forth) and this itself means that there is at least another $1.34trillion – $2.68trillion in interest servicing costs which are being generated every year along with the parabolic trajectory of the principle debts – again, all of which must be serviced in dollars.
If we included the Telegraph’s numbers, this totals up to $76.9trillion in demand for dollars per year which is growing at a rate of about $1.5trillion per year (which means that this debt will double in the space of 30 – 40 years).
So therefore, this means that our earlier estimate for the total supply of both the on-shore dollar and the off-shore dollar (which we quantified at $33.8trillion) is actually far far smaller (by a ratio of just under 1:2) than the demand for dollars (which we have just quantified as standing at $61trillion at the low end, and $76trillion at the high end).
So in short, this is pure supply and demand.
There is roughly twice as much demand for dollars in the world as there is supply of dollars.
Moreover, when banking debt is paid down, dollars do not simply continue to circulate. As a matter of fact, they are actually destroyed during the process of paying-down debt.
So as such, the “demand side” of this equation should not be thought of a distributive sort of demand which we typically see in equities wherein assets can be bought and sold many times over.
The demand side of this equation is actually destructive because banking debt destroys dollars when principle payments are made.
The Supply-Side Of the Dollar Equation Is Also Highly Questionable
It might seem self-evident to most people that the Federal Reserve is the primary supply of dollars.
This is flatly untrue however.
The Federal Reserve (as we explore in our article on stimulus here) can not themselves print dollars and as such the “money creation” engine does not lie with the Federal Reserve.
The money creation engine actually lies with the private banking system and what the FED undertake, is purely a matter of controlling the collateral base of the banks themselves.
The Federal Reserve clarify this in a piece on the St. Louis Federal Reserve website.
“So, in that sense, we can think of ‘printing money’ as adding reserves to the banking system,” said David Wheelock, vice president and deputy director of research.
Because “reserves” are not “cash” (and in fact can not be readily liquidated or spent or lent in the same way that “cash” can), there is no actual money creation which takes place at the Federal Reserve and so instead we must pay attention to what the private banking system is doing in order to assess the supply of dollars.
In fact, if we look at what the private banking system is doing (as we also examine in our piece on stimulus) private sector credit creation is experiencing it’s biggest contraction since 2008.
This means that, ultimately, demand for dollars (in the form of debt) is growing exponentially each year, while the legitimate supply is contracting.
So although we might have experienced a temporary “sugar rush” of bank lending (probably due to people relying on debt to get them through the COVID-19 crisis), bank credit creation (and thus money creation) is experiencing a crunch which may yet prove to be on-par with the contraction in credit observed during 2008.
This means that the dollar’s supply-side dynamics are highly questionable.
A Quick Word On Inflation
Due to the popularity of Austrian Economics, the popular conception of inflation is that the Federal Reserve is the ultimate dominant factor in producing inflation.
This is because these people flatly don’t understand monetary theory and in that respect, Austrian economics is more of a doctrine of morality than a science.
What we have to remember is that inflation has ultimately been sluggish since the Great Financial Crisis.
We can see this by looking at a chart of inflation since 1992 from FRED
We can clearly see that the trend is for lower inflation over time with a definitive trend of lower-lows and lower-highs being visible over the long-run.
There are many reasons for this (which I will go through in another article). However…. considering the current panic over inflation we must take-stock of what is actually producing it.
Here is a chart which graphs a basket of commodities versus the US dollar index.
What this demonstrates, is that the commodities bull-run which began in 2020 and has been one of the core drivers of the recent inflation is ultimately a byproduct of the dollar-pullback which began in 2020, and started reversing in 2021 (and has since pulled back slightly again reviving the inflation panic).
Secondly, we have to remember that the government (as distinct from the Federal Reserve central bank) engaged in one of the biggest monetary stimulus programs in the world in sending out stimulus cheques to people during a time which supply chains were disrupted.
However, it’s worth bearing in mind that there is ultimately, no more stimulus on the horizon and most of this was derived from government debt which must be paid back.
Conclusions
Being dollar bullish is not the most popular position to take in general. Largely because of general investor dogma and the fact that dollar strength is generally not good for assets.
However… the facts are that none of the doomsday predictions put out for the dollar have ultimately come to fruition.
We had no hyperinflation despite the trillions of dollars worth of stimulus, the dollar is still the global reserve currency, the dollar is still stronger today (after several pullbacks and a global crisis) than it was in 2014 (just 7 years ago).
Moreover, inflation is actually sluggish given the historical trend in spite of the short-term panic over it we are seeing.
We need to always make sure we assess the USD in the cold light of day (and in fact this should apply to all of our positioning and analysis).
https://www.telegraph.co.uk/business/2017/09/17/bis-discovers-14-trillion-dollar-debt-offshore-hidden-footnotes/
[1]https://www.bis.org/publ/work753.pdf
[2] https://stats.bis.org/statx/srs/table/e2?m=USD