The Strength of the US Dollar and Invisible Pressure on the Fed

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Last week, many readers sent private questions to Viet Hustler about how much longer the USD value will continue to rise.

This question is quite difficult to answer, as it completely depends on the Fed's interest rate and monetary policies — compared to other Central Banks. However, the good news is that the Fed is under a lot of pressure from capital markets and global trade — to cut interest rates and lower the credit tightening (QT) level soon.

To clarify the above issue further, Viet Hustler will summarize the big picture position of the USD -the US government's view on their currency - and pressure of the USD value on the Fed in this week's Macroeconomic article.

Disclaimer: Some of the views below come from the author's personal opinion, and are not investment advice at all!

USD: America's Economic-Political Strength - Weight on the Shoulders of the Federal Reserve 

The USD is not only the US currency but also the world currency (world currency):

• The US economy accounts for only about 25.5% of global GDP in 2022 (and only about ~14% of global GDP on a PPP basis). 

• But the USD participates in 88% of all foreign exchange transactions (2022)….

• …. and accounts for about 59% of global foreign exchange reserves (2022).

  

• In international trade, the USD dominates the majority of import and export orders in most continents:

  

• Read more: In god we trust - faith in the USD position

• Not to mention the position of the Dollar in commodity and energy transactions (read more about PetroDollar system).

The tremendous strength of the Dollar in the global economy has brought corresponding power to the US government:

US economic/financial sanctions are a death sentence in terms of trade!

Countries subject to economic/financial sanctions will face the following issues:

1. Local currency depreciates

2. Leading to high inflation (possibly runaway) => Interest rates must rise to curb inflation => Making the economy prone to recession.

3. Reduction in FDI inflows to that country + reduced export turnover => Double recession (from both domestic and external factors)

4. Increased borrowing costs on international markets - or even unable to borrow => public debt crisis.

FYI: Some recent damages to Russia due to US sanctions

However, the global strength of the USD is a burden for the Fed in the role of “World Central Bank”:

The Fed always has to conduct currency swaps with other Central Banks…

• to provide USD liquidity to commercial banks around the world during global and regional economic crises.

  • Read more: Currency swap mechanism between Central Banks

    

• FYI: The Fed has conducted a series of large and small swap transactions with ECB, BOE, BOC, and BOJ this month as those regions are at risk of recession and under pressure from the rising USD.

  

… not to mention that any policy decision by the Fed affects global capital markets and international trade activities…

The current US trade deficit itself is how the US supplies USD to the global economy: 

• The US is a major trading partner for most other continents.

• The US pays USD to exporters around the world who sell goods to them.

  • Along with the stability of USD value, the large import demand in the US further increases the importance of USD in international trade…

    

So, under what circumstances does the global “Dollar Economy” system operate well?

The global USD-denominated economic-financial system operates best when:

1. Abundant USD supply

2. Low US interest rates

3. The value of other currencies (in USD terms) remains sufficiently high. 

Why?

1. Abundant USD supply (USD liquidity) makes it easy for businesses worldwide to access USD loans.

2. Low US interest rates make USD borrowing cheap.

3. Other currencies maintaining value against the USD allows local businesses to buy USD without excessive costs in their local currency.

These conditions help maintain the popularity of the USD in trade transactions.

• Only with international trade needs do countries gradually reserve large amounts of USD and US bonds.

• Due to US economic prosperity + USD popularity, USD-denominated assets also become valuable and highly liquid.

However, the current situation is the opposite: 

1. USD supply declining due to Fed's quantitative tightening (QT)

2. US interest rates have gradually risen over the past more than 2 years.

3. These two factors push the USD value too high, causing other currencies to depreciate (against USD).

This is causing stress to USD-denominated economic activities worldwide:

• Debt of emerging economies will mature in large amounts this year and in coming years:

  

• Since late 2022 to 2023 (when Fed raised rates), more emerging country governments have had to borrow at rates >9% (red column in the image below).

  • Note: these countries mostly borrow in USD but rely on local currency tax revenues to repay (Original Sin).

    • The rising USD value increases their public debt burden.

If US interest rates do not decrease this year: next year a series of emerging economies may default – creating a global sovereign debt wave!

De-dollarization movement stemming from emerging economies' difficulties

Large central banks can naturally cope with high USD situations:

• ECB maintains the highest interest rate in over 3 decades:

  • Actually, with 2.4% inflation in April, ECB could have cut rates from May but delayed to June-July.

  

• BOJ still sends a strong message to raise rates despite Japan's economy possibly falling into recession.

  

• Inflation in Canada down to 2.7% in April + mortgage debt crisis, this country's central bank may cut rates this summer.

  • But with room to maintain high rates, they may keep rates high to protect their currency.

  

And most of these central banks have sufficient resources to intervene and manage depreciation when necessary:

• For example, BOJ spending 62 billion USD to defend the Yen last month.

But emerging countries cannot do this: this is the time for them to support the de-dollarization plan!

• However, these efforts are just budding mainly in commodity and raw energy markets.

• But in financial markets: demand for USD-denominated US corporate bonds remains strong.

  • Simply because US borrowing rates are rising and these bonds remain safe.

  

• However, the problem is not only in demand… but in bond supply: how long can businesses withstand such high borrowing cost pressures?

• And the problem is not only with US businesses: but also foreign businesses issuing USD debt!

Non-US businesses issuing USD bonds – but earning in local currency: their default risk increases if their local currency depreciates.

• Especially when the amount of global USD-denominated bonds maturing this year is extremely large.

  

• This is the motivation that allows them to participate in the de-dollarization movement: by issuing debt in other currencies!

This could also be a reason why demand for US government bond reserves has significantly decreased in the auctions last week:

Views on the USD from US presidential candidates and invisible pressure on the Fed

Money supply and monetary policy in the US are decided by the Fed, but import tax and fiscal policies are decided by the US government — and proposed by the US president.

Observing the crises of the 1970s - 1980s, Trump has quite traditional views on trade and exchange rates. 

• Trump's previous campaign focused on the slogan: Make America great again,

  • … protecting the US industry and exports by imposing import taxes. 

•  For him, a too strong USD will “kill” the US manufacturing export industry, benefiting China as a major exporting country. 

The Biden administration, on the surface, has not had much reaction to the USD appreciation…

• …. even somewhat seeing it as a sign of strong US economic recovery. 

• However, Biden's economic advisors surely understand that the decline in USD money supply is reducing global demand for USD borrowing

  • … leading to a decline in USD reserve demand (through US Treasuries).

• Therefore, the Biden government's fiscal policies (such as student debt forgiveness, business subsidies, increased public spending…) may aim to increase money supply (contrary to Fed policy).

  • And in fact, M2 money supply has turned around and increased again in April!

    

And pressure on the Fed:

• Even though inflation is still persistent, even though Fed members continuously call for monetary policy not tight enough… then

• …. the Fed still announced a reduction in the QT cap from June in the latest FOMC!

• A main part is due to pressure from capital markets and international trade — which are being harmed when the USD appreciates too quickly.

However, slowing QT in the current context with the threat of supply shock returning will only prolong the Fed's inflation fight! 

CONCLUSION

The Dollar currently still holds the role of the world's primary currency: accounting for 88% of forex transactions, 59% of currency reserves, and 46.5% of international payments (SWIFT).

However, this global Dollar economy is only truly healthy if in the US: abundant USD supply and low interest rates — to help other currencies maintain a certain value. However, current US monetary interest rate policies are making USD supply relatively scarce, increasing capital costs and causing the value of other currencies to decline against the US Dollar. This not only increases the default risk of non-US companies borrowing in USD, but also limits USD trade transactions — accelerating the de-dollarization plan.

The great position of the USD in global trade - finance always goes hand in hand and maintains the economic and political strength of the US. If the USD is no longer favored, US sanction decisions against adversaries will no longer be effective. Therefore, maintaining the popularity of the USD is maintaining the US's economic-political influence globally.

Nevertheless, the strength of the USD is also a heavy burden on the Fed's shoulders as it has to play the role, not only regulating the US economy, but also as the World Central Bank. The Fed may have faced pressure from capital markets and international trade when deciding to cut QT - but this means the Fed has to prolong its inflation fight!

How to Protect Your Account?

Basic Knowledge About Hedge And Diversify

Faced with upcoming market fluctuations that may occur, protecting the account is extremely important but doing it effectively is not easy. In the seminar 1 month ago, Steve delved into factors determining the origin of risk and when to use different Hedge and Diversification methods. This is a limited-time video that Steve will only make public for 1 week.