If this is what a bad year for the dollar looks like, I'll take it. Widespread predictions of a significant retreat after a bumper 2022 haven't come to pass. The greenback is still the place to be. Not just in good times, but when the rest of the world looks less than enticing. No mere currency, it sometimes resembles a medieval fortress, complete with a moat.
The epic rally last year was always going to be tough to repeat. So it's not too shabby that the dollar is pretty much where it traded on Dec. 31, according to the Bloomberg Dollar Spot Index. This is a product of several forces: The Federal Reserve has laughed interest-rate cuts out of the room, China's rebound has fizzled, and Japan can't decide whether it wants to unwind ultra-loose money or not. The euro area is struggling.
When in doubt, flock to the buck, especially with the Fed showing few signs of relenting in its inflation fight. Never mind that for years, it has been fashionable to assert that the US is in long-term decline at the hands of China, a view that has come in for some refreshing scrutiny. Could there be deeper forces at work? A paper from the New York Fed in December attributed much of the dollar’s primacy to a so-called “Imperial Circle.”
The basic idea is that the dollar is not just integral to world commerce, but is increasingly important. When the Fed lifts rates, the dollar gains, mostly at the expense of emerging markets. But when the slowdown comes as a result of that tightening, the effects are felt more keenly beyond US shores than domestically. This is because exports and imports account for a relatively small part of the US economy. The demand for safe and liquid assets — chiefly, US Treasuries — also plays an enormous role.
There's irony and no small amount of tension in the concept. The dollar has become more dominant even as the US recedes as a proportion of global gross domestic product, relative to the likes of China and India. This asymmetry is a key element in the thesis, Gianluca Benigno, one of the paper's authors and now a professor at the University of Lausanne, told me:
The weight of the US economy is declining over time because of the rise of Asia. But at the same time, the rise of Asia is combined with a more prevalent role for the dollar… Many countries are short safe assets. This is very important. Until you break that, it’s difficult to replace the dollar, even if you start invoicing in something else. Safe and liquid is what pension funds in Asia demand because those countries do not have the capacity to absorb their savings. That creates a natural driver of dollar demand. It underpins the hegemon.
Developments since the paper was published support this. Concerted Fed tightening is just about done, but has given way to a stance of high-for-longer. Under this scenario, which Chair Jerome Powell may reinforce in his speech at Jackson Hole, Wyoming, on Friday, rate cuts are unlikely until well into 2024.
Coupled with China's softness, the resolute Fed presents unenviable choices for many central banks in Asia, and emerging markets broadly. They can reduce rates to alleviate a slowdown emanating from China. Yet, doing so will place their exchange rates against the dollar under pressure. “It's a big divergence and creates a dilemma in many emerging markets in terms of policy choice,” observed Benigno.
There are weak spots in the dollar’s rule. Strains elsewhere can sometimes become so significant and destabilizing for US markets that the Fed is forced to alter course. Following a period of stasis, Alan Greenspan cut rates quickly in 1998 after Russia’s default. The euro debt crisis was one reason why Ben Bernanke and Janet Yellen proceeded carefully to withdraw stimulus that was deployed during the Great Recession. China has also weighed: A botched yuan devaluation in 2015 contributed to Yellen hiking just once that year, as opposed to the multiple increases that were projected.
George Soros referred to the greenback’s imperial qualities in a 1984 piece in the Financial Times. Defense and the consequences of Ronald Reagan’s weapons buildup were on the billionaire’s mind. Thanks to Pentagon largesse, tax cuts and no corresponding reduction in spending, the budget deficit skyrocketed. While great for the US and a boon for Reagan in an election year, significant burdens were imposed on countries from which capital fled. A benign circle for America was vicious elsewhere, wrote Soros, who predicted a crisis.
Troubles did beset Latin America, and in an effort to reduce trade frictions with allies, then-Treasury Secretary James Baker negotiated the Plaza Accord the following year. The pact aimed to weaken the dollar against the West German mark and the yen. As contentious as Plaza was, Baker's work was fairly easy compared with what would be required for any major realignment today. Germany and Japan were treaty partners of the US. The Soviet Union was nowhere near as embedded in the world economy as China. Beijing’s prowess at attracting supply chains over the past three decades, notwithstanding, China doesn't have a currency to back its ambitions — yet.
The world is the dollar’s to lose. The rest of us just live there.
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