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Why ‘The Tide Is Going Out On US Dollar Exceptionalism’

In “Exceptionalism Lost”, I placed recent US dollar weakness in the context of America’s failure to stop the spread of COVID-19. In previous work, I’ve suggested that fractious domestic politics and social tensions threaten to forever alter the way the rest of the world perceives the US.

The transmission mechanism from the ongoing epidemic to the currency is relatively straightforward. As more states are forced to pause or rollback the re-opening push, the prospect of a durable economic rebound becomes commensurately more remote. The weaker the economy and the further out the recovery, the longer monetary policy will have to remain accommodative and the more fiscal stimulus will be necessary to help cushion the blow from what could become structurally higher unemployment and persistently depressed consumer spending.

Between the weaker economy, lower for longer rates, ongoing asset purchases from the Fed, and consistently large deficits, the fundamental case for the dollar is eroded. At the same time, the perception that the US suffers from intractable political dysfunction and growing politicization of monetary policy, undermines investor psychology, as does pervasive societal unrest tied to myriad inequities and prejudices seen as increasingly incompatible with the prevailing attitudes and ideals that characterize other modern, developed nations.

Read more: Exceptionalism Lost

Add to the above growing concerns about the extent to which the dollar and the US financial system have been weaponized to punish other nations for perceived transgressions both large and small, and the fact that stability in emerging markets hinges to a great degree on the Fed not erring by over-tightening during a hiking cycle, and there is a very good case to be made that gradual de-dollarization is desirable.

Regular readers know I do not believe that rapid de-dollarization is feasible, let alone likely. As discussed here earlier this week, there are logistical hurdles that are simply too high to clear. For example, the petrodollar system is deeply entrenched, and China has to recycle its savings. Arguably, there’s no market deep enough and liquid enough to accommodate those flows outside of US Treasurys.

And yet, the de-dollarization theme and the (related) idea that American exceptionalism is fading, are suddenly en vogue, thanks not just to the decline in the dollar itself, but also to gold’s furious rally.

In a note out Wednesday called “The tide is going out on USD ‘exceptionalism'”, Deutsche Bank’s Alan Ruskin touches on a number of the points mentioned above.

“A big cycle USD top is very likely in place”, Ruskin writes, kicking things off by noting that after three years of ranking first among G10 countries in both short- and long-term rates, “US yields are now far from exceptional, and are the most visible FX metric that ‘the tide on USD exceptionalism’ is going out”.

Of course, when the Fed rushed to cut rates to zero, the world was in a panic. In March, the dollar surged alongside US real rates, but that episode reflected a state of absolute chaos wherein everything that wasn’t tied down (including gold) was sold indiscriminately to raise USD cash.

The Fed stepped in with swap lines and a foreign repo facility (both of which were extended to March of 2021 on Wednesday) and things calmed down.

With that episode in the rearview, “we still do not have a clear understanding of whether the collapse in USD rates are fully priced, and what constitutes a source of stable US Current Account financing”, Ruskin says.

But it’s not just the crumbling of the rate differentials pillar. Remember, QE functions to create de facto negative rates while simultaneously absorbing issuance tied to fiscal stimulus.

“Quantitative easing makes up for the constraints of the zero rate bound [and] facilitates smooth fiscal financing”, Ruskin notes, adding that,

Initially the FX market rewarded proactive Fed QE, with a stronger currency, but like we saw back in 2009 – 2012, QE when repeated, starts to become a symbol of ‘weakness’. At a minimum, it shows that past easing has been insufficient, or, that from a fiscal perspective, more money financing of debt is necessary. In short, we are already at the stage where more easing from the Fed will be regarded as a USD negative.

Needless to say, nothing in Jerome Powell’s remarks Wednesday suggested that the Fed is anywhere near contemplating tighter policy, and will surely resort to more easing at the first sign(s) of real trouble, which could be coming sooner rather than later given the leveling off of the recovery trend.

Ruskin goes on to document the same points made here on Monday regarding the country’s inability to get control of COVID-19.

“Of late, the biggest knock to ‘US exceptionalism’ has been precipitated by the virus data”, he writes, noting that “US ‘virus divergence’ from many other developed countries has triggered expectations of economic divergence, and more policy easing that is a clear USD negative”.

Meanwhile, the “twin deficit” problem is a persistent knock against the greenback and it’s especially poignant now.

One thing I’ve been keen to emphasize is that almost every country that “counts” (so to speak) is borrowing and spending, so it’s not as if the US is alone. I ran through the numbers on that via a few handy visuals in “The Dangers Of Deficit Dogmatism And The Courting Of Disaster“.

But Ruskin notes that even as “most countries are going to see the worst general government deficits in peace-time… the US suffers from the worst starting point among OECD countries, and the post-COVID fiscal actions have supported short-term consumption more than sustained employment”.

And then there’s the geopolitical angle, which I tend to emphasize by force of habit.

Sino-US tensions ratcheted materially higher last week with the forced closure of the Chinese consulate in Houston and an in-kind shuttering of the US mission in Chengdu. And that’s to say nothing of Mike Pompeo’s abrasive speech in California and visa fraud charges leveled against a handful of Chinese researchers.

Deutsche’s Ruskin offers the following color on spiraling tensions between the world’s two largest economies:

What has amplified USD worries is that the so called US – China decoupling will also act to undermine the USD’s reserve status. In the same way as both the US and China are trying to curtail interdependence when it comes to technologies; natural resources; and now medical supplies, so China will likely strive for independence from the USD’s dominant role as an international means of exchange. This encroaching challenge to the USD’s ‘medium of exchange’ status, is interlinked but different from the worries about the USD’s ‘store of value’. The latter is usually where worries about the USD’s long-term reserve status are concentrated, and of course is about to be challenged by unprecedented US debt monetization.

All of this raises a number of longer-term questions, but in the short- to medium-term, traders and investors are attempting to discern whether recent weakness and the factors set out above are conducive to a rapid slide in the greenback or a kind of “glide path”.

For his part, Ruskin writes that “past experience suggests it would take a C/A deterioration of 2% of GDP or more to set in [motion] forces for a USD downside overshoot”. A smaller adjustment would entail a less dramatic downward trajectory, he says.

For me (and likely for most readers), the larger question around the dollar’s long-term viability as the world’s preferred medium of exchange and default vehicle for savings is far more interesting, at least as a subject for discussion and debate.

As ever, I’m skeptical of the notion that the dollar will lose its reserve currency status at any point in my lifetime. To adapt a great Harley Bassman quotable, “I am certain of the denouement, but it is possible its date is vastly longer than my career”.


 

7 comments on “Why ‘The Tide Is Going Out On US Dollar Exceptionalism’

  1. In addition to concerns over the fade of US exceptionalism – other countries focus efforts and resources to increase their opportunities of exceptionalism.

    From Reuters today — India is increasing their spending on education from 4% to 6% of GDP. Currently, 750,000 Indian students study abroad and the country to making an effort to get top global universities to open campuses in India to bring students home. They are expanding higher education to 50% of high school students by 2035- adding 35 million students.

    It is not just the mistakes that US is making, the rest of the world is catching up.

    We are not “invincible”.

    • It wouldn’t hurt so much if the US hadn’t pissed away it’s hegemony. It really was a once in 500 years opportunity that we were presented with these last 75 years. Seems now that I was naive; human nature was always going to prevail. I was hopeful of a greater human and social transformation. The US has been a force for much, much good these last 75 years. Just pisses me off that we couldn’t have done more with the opportunity. Human nature was a big part, but so were the blunders of the US’ elites these last three decades (which is human nature…sigh).

  2. I’m with you H re the status of the dollar in our life times.

    Despite our problems here in the US, I remain long-term optimistic about the US’s prospects. This even considering climate change, COVID-19, risk of authoritarianism, hot war with China, undermined elections via cyber warfare, the social/political dysfunction, out of touch elites, and that we have too many poor children who don’t get enough to eat. It’s the third most populous country (that will slip to maybe fourth) with a huge economy and the world’s best geography. (Oh, forgot the risk of revolution here in the US.) It’ll suck for the US for the next six or seven years. But, I don’t see a replacement for the dollar as either a store of value or medium of exchange.

    Oh, I just heard and watched Mitch McConnell on TV from an interview earlier today. Depressing. He was uttering senile nonsense. Almost incomprehensible. He was espouing talking points form a bygone era. He is an ancient person out of touch with about 270M people in the US and the current, world reality. Revolution in the US is inevitable. We are doomed after all as is the USD.

  3. I look forward to more articles on this topic.

  4. Tom Swift

    Ray D takes a really long view of things; whereas I just use Genrational Dynamics / Cycles.
    Start looking back using 30 year cycles and you will see repetition of boringly repeated “changes”.
    The same hat just gets passed around. Any reserve currency is the one that has the best ROE.
    The only true breakthrough I’ve noticed is the invention of the zipper.

    • Zippers are truly great inventions until they suddenly break on you…then the thing is pretty much always a throw-away.

      For me these pandemic days, the greatest invention of my lifetime is the microwave oven. Yesterday’s leftovers are hot and near-tasty again within seconds, bringing me gratification so I can return back to the grind here in my own castle.

  5. Sounds like Ruskin is not a MMT fan, and not concerned about strong dollar induced deflation. I will have to research what currencies could win in the expected downturn. Euro? Swiss franc ? HKD?

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