Writing to a London newspaper in response to persistent rumours of his own demise American author Mark Twain (real name Samuel Clemens) remarked that “the report of my death was an exaggeration”.

Ordinarily in times of trouble for the dollar the US Treasury responds in such a fashion. “A strong dollar is good for the US economy”, is a refrain oft heard, regardless of the political stripe of the incumbent in the White House. To be fair to Treasury Secretary Scott Bessent he has tried. Not particularly hard, and certainly not convincingly, but he has tried. Maybe the problem has been that he seems to express a personal belief rather than a statement of government policy. I guess to do the latter would be an obvious and direct challenge to his boss and his coterie of advisers. They seem far less attached to the prior political consensus about the virtues of a strong greenback, and Donald Trump has amply demonstrated his willingness to fire and hire if his underlings cease to toe the party line.

In the aftermath of April’s tariff-related fireworks, markets have done what they do best – ignore risks, downplay bad data, pop on the rose-tinted spectacles and get back to grabbing at risky assets with both hands with nary a hesitation at the price being paid. To be fair to the modern hordes of dip-buying, diamond-handed HODLers – it’s been a successful strategy. As many such unconventional strategies have been historically. Until they’re not, of course.

Thus, when looked at in the rear-view mirror, the chart of most assets has the appearance of a V. Those assets which fell in the aftermath of Liberation Day have rallied since and vice versa. However, there is one rather glaring and obvious exception – the US dollar. It happens to be a biggie.

This isn’t the first time that the market grapevine has been all of a flutter with discussion and debate about imminent dollar demise. I would say there have been two or three periods over the last decade or so when investors openly and widely questioned whether the dollar was at risk of losing its dominant role in the global monetary order.  On the prior occasions I was entirely dismissive. For a few critical reasons:

1. TINA. There is no alternative.

This is a pretty big one, as it goes. The size and scale of the pool of liquid, investable US assets just dwarfs the competitors. If global reserve managers cannot save in a particular currency, then they will not wish to finance trade in that currency.

2. Supply of liquidity.

The US economy is 25% of global GDP (in US dollar terms) and it runs a near-permanent current account deficit of around 4% of US GDP. That means it is supplying the dollars necessary to grease the global system. In fact, so large is the need for offshore US dollars, because of the extent of global US dollar borrowing, that even this huge current account deficit isn’t sufficient once the velocity of offshore dollars drops – i.e. when things go bad. At that point dollars are hoarded and liquidity dries up. The global system would seize up were it not for the interventions of the Fed – hence why it has bilateral swap lines with multiple central banks across the globe. Of course, by doing so they create a moral hazard, which simply encourages more US dollar borrowing and thus an even bigger bailout the next time things go awry…but living with dangerous moral hazards and perennially relying on central bank technocrats to bail out bad actors seems to be our thing nowadays. Potential competitors fall at this hurdle – Japan, the Eurozone and China all run current account surpluses. They would be starving the global system of the currency needed to facilitate trade flow. Were they to take up the dollar’s mantle any of these economies would need to upend their economic model – become global consumers rather than global producers. Of course, it could happen in time, but for the foreseeable future it is unthinkable.  As an aside, it was essentially this dynamic which ushered forth the end of sterling’s reign as the global reserve currency. The UK simply could not run large enough current account deficits to supply sufficient sterling to the growing global economy. The UK economy would have sunk under the weight of its appreciating currency.

3. The dollar smile.

This framework was established by former Morgan Stanley strategist Stephen Jen and we on the fixed income desk at Marlborough have historically been big supporters. The basic notion is that the US dollar serves two masters. It can appreciate when times are good and growth is strong, provided that US growth is best (the right-hand side of the smile and the dominant paradigm since about 2014). And, it can appreciate when times are very bad and investors are seeking quality, safety and liquidity that only the dollar can provide (the left-hand side of the smile). The middle of the smile has been a rare sight in recent years. It requires growth to be sufficiently positive that investors don’t seek safety, but US growth must be lagging to the extent that investors prefer to allocate their global exposure to the likes of Europe, China and Japan. Therein lies the problem. All three of these economies have faced significant structural challenges and, most pertinently, all three run what amounts to a mercantilist business model – meaning they rely on exports to drive growth. Thus, if their currency appreciates that becomes a significant headwind to growth in a way that an appreciating dollar does not for the US (its growth is debt and consumption driven. So, in a sense, a stronger currency can boost growth by lowering the price of imports). The middle of the smile has been an unstable economic equilibrium. It is worth noting that 2017 was the one year where we spent meaningful time in the middle of the smile and the resultant appreciation of the euro sowed the seeds of its own demise, bringing German growth back down to earth with a bump.

4. Multiple other reasons.

These have added up to a death knell for alternatives to the mighty dollar – the yuan’s lack of convertibility (yuan cannot leave China – which is pretty much the most basic requirement for a reserve asset), the military strength of the US and its role as a global political leader and the existence of an entire global payments system based on the dollar (SWIFT, CHIPS etc).

So previously my scepticism towards the dollar’s decline was justified. WARNING: I am about to use the most dangerous words in finance… ‘this time, it’s different’. I am going to regret this, surely?

To be clear – all of the points above about the dollar’s dominant reserve status are still true and still valid. The US dollar is NOT about to be replaced as the world’s reserve currency. None of the contenders are even close. All things considered, the euro is closest. But the lack of liquid, risk-free investable assets is a big problem and it would be politically toxic to try to turn a poorly constructed monetary union (without a fiscal union) into something capable of surviving and issuing sovereign risk-free Eurozone assets.

This time it’s different, not because the alternatives are stronger, but because assuredly the US dollar is weaker.

When the history of this episode is written, I strongly suspect that historians will identify as a turning point not the election of Trump for a second term, but the acceleration of the use of the US dollar as a political weapon. In the aftermath of Russia’s most recent invasion of Ukraine, the US government took policy steps that it has increasingly employed when faced with a rogue sovereign operator. It used the US dollar system as a weapon. This time, Washington went further. Confiscating the dollar-denominated reserves (savings) of the Russian state will have reverberated across the capital cities of the world. All the wealth that a country has accumulated to manage monetary policy, massage the exchange rate and save for a rainy day could be gone in a heartbeat – if you don’t dance to whatever tune the US is playing at that moment. Rainy-day national savings that could be here today but gone tomorrow are no savings at all. There doesn’t need to be a ready replacement for the dollar for that reality to have implications. Any country not fully aligned with the US, and certainly any country aligned with a known enemy of the US, is instantly at risk. Selling all their US dollars is not feasible, certainly not quickly, but diversifying away from the greenback is possible. And that’s just what we have seen. In fact, to be 100% honest, diversification away from the US dollar long predates these recent episodes – it has been ongoing for decades. It is no surprise to us that gold has appreciated so much. It is, in many respects, the ultimate reserve asset and has been since near the dawn of civilisation. It’s inert, it’s immutable and it’s the only asset which isn’t someone else’s liability. In most large European countries, gold makes up the dominant proportion of reserves. The US, Germany and Italy all hold 75% or more of their reserves in gold. The UK, of course, does not. This is because when he was Chancellor Gordon Brown sold all the UK’s gold at an average price of about $260/oz. That’s almost exactly one tenth of the gold price in today’s market. In China the figure was 3%. A mere 3% of its reserves were in gold. But the US government’s actions have seen a response. The People’s Bank of China has been consistently and persistently buying gold over the last 24 months. Gold now makes up 6% of reserves. There is a long way to go.

For us, however, this is not the big story. In our view, the big story here is portfolio flow. As mentioned above – for most of the last decade or so we’ve been on the right-hand side of the smile. A pro-growth world where the US is at the front of the pack. That paradigm was so persistent it was given a name, US exceptionalism. Global investors could buy unhedged US equities and make money both ways. US equities always go up and so does the dollar. Significantly above-average equity returns, year after year, turbocharged by currency gains. It’s been a no brainer. That’s why US equities are 70% of the MSCI World Index and that’s why some of the biggest global institutional money pools have such high exposure to US assets and such low currency hedge ratios. Small, open, exporting economies in Asia are some of the biggest, relative to the size of their economies (Taiwan, South Korea and Malaysia to name a few), while Japan and the Eurozone are the biggest in notional terms. In all cases, private and public sectors have been playing this game. But now, as the performance of unhedged US assets deteriorates relative to the performance of hedged US assets or domestic assets, the calculus for these investors will shift significantly.

If I push a boulder to the top of a hill (I am scrawny and sparrow-legged so that’s unlikely, but please bear with me) and manage to balance it on the edge of a precipice, the image has the appearance of stasis. In fact, that circumstance is filled with energy. Potential energy. The energy I expended getting the boulder up the hill, against the wishes of gravity, is now stored in that precarious boulder-on-a-precipice situation. One tiny little nudge in the right direction and that boulder will come careening down the slope – well beyond the point from which I initially began pushing it up the slope.

The persistence of the right-hand side of the dollar smile was a hill. Global investors responding to that environment and hoovering up unhedged US assets were the “me” pushing that boulder up a hill. The situation in front of us today is loaded with potential energy. Forget reserve status – if global investors begin to respond to the shifting sands by selling US assets, or even just increasing their currency hedging, the potential energy that could be unleashed is gigantic.

‍

‍

This article is provided for general information purposes only and should not be construed as personal financial advice to invest in any fund or product. These are the investment manager’s views at the time of writing and should not be construed as investment advice. The opinions expressed are correct at time of writing and may be subject to change. Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.