The U.S. dollar could start to lose its world reserve currency status in the 2020s. Not all at once, and not overnight, but steadily over a period of years.
In fact, the process may have already begun, which would partly explain the dollar’s powerful downtrend from March 2020 onward.
At the moment, the dollar is still a world reserve currency without peer. It has the largest share of global currency reserves by far, indicating central banks around the world have a strong preference for dollars.
According to data from the International Monetary Fund (IMF), the U.S. dollar had a 61.3% share of currency reserves in the second quarter of 2020.
That was more than triple the share of the No. 2 world currency, the euro, which came in at just 20.3% of reserves. The Japanese yen, at No. 3, was just 5.7%.
Central banks hold currency reserves as a form of insurance and a means of trade. For instance, if a country does a fair amount of business with the United States, it may want to have U.S. dollars on hand as a form of backstop for its own local currency.
The insurance aspect comes in handy because, if the local economy and the local currency get knocked around, the dollars can be used in a pinch. This is the main function of reserve currencies: To provide a measure of safety to countries that do business in currencies other than their own, and thus subject themselves to risk factors beyond their own borders.
A country with heavy dollar reserves may also routinely collect dollars in exchange for the goods that it exports. Those dollars might be held onto for safekeeping and parked in U.S. treasury bonds (which are like dollars in a longer-term form).
Then, too, the U.S. dollar is so popular, it is commonly used in trade transactions that have nothing to do with America at all. This is an offshoot of the dollar’s common acceptance. If two countries with little-known currencies want to do business with each other, the U.S. dollar — like a trusted and popular middleman — is a natural third-party choice for pricing the transaction.
The dollar’s popularity as described also helps explain why global commodities are generally priced in dollars. For decades it has been the most efficient thing to just quote prices and run transactions in the currency everyone is most familiar with.
This is why, with a greater than 60% share of reserves worldwide — and a comparable level of use in trade transactions — the dollar can punch so far above its weight in terms of global economic involvement.
When adjusted for purchasing power, America’s share of economic output, as a single-country percentage of the global economy, has been in the range of 16% to 17% for the past five years, according to Statista data.
The extra weight for America’s currency, in terms of the U.S. dollar being more than 60% of currency reserves, is a function of who holds dollars and who uses dollars, and why.
With that brief refresher, we can cover basic reasons why the dollar will be so vulnerable in the 2020s, and what it means to say the dollar’s world reserve currency status will fade.
Some of the pressures the dollar will face in the 2020s are as follows:
- Greater isolationism on the part of the United States will mean less trade with the rest of the world. That will reduce the flow of dollars outward, and the total number of dollar transactions, which in turn will reduce the global appetite for dollar-denominated assets.
- The popularity of the euro, the world’s No. 2 reserve currency, is set to increase as countries like Russia and China deliberately try to move away from the dollar-based pricing standard. Both Russia and China are wary of American power, and jointly they are trying to use the euro more often for energy transactions (e.g., Russia selling oil and gas in euros and China buying it in euros). A greater use of the euro in trade transactions will reduce dollar demand.
- The acceleration of technologies like 3D printing, and an increasing shift toward robotics and virtualization, means the total amount of cross-border trade is likely to decline in coming years. Put another way, countries will trade less “stuff” with each other when more stuff is made at home. That will reduce the need for the dollar as a transactional go-between.
- The rise of cryptocurrency solutions and instant-settlement payment rails reduces the need for a trusted third-party currency as a go-between for transactions. In the past, a trade transaction between two countries could take days to settle, increasing the currency risk of the transaction. In the transactions of tomorrow, conversion from one currency to another can be instant or very close to instant — again reducing the need for a third-party world reserve currency.
- As hard assets become “tokenized” and made liquid via blockchain technologies, it becomes easier to store wealth in hard assets rather than fiat currency or government securities. Imagine a cryptocurrency-tokenized version of Canadian timberland, for example, as such that one could put money into timberland (or take it out) with a surprising degree of liquidity. As various forms of tokenized hard-asset alternatives become more popular, the demand for dollars will fall.
- As issuer of the world’s reserve currency, the United States can take advantage of its so-called “exorbitant privilege” by printing and spending a lot of new dollars. With U.S. treasury yields below the rate of inflation, this is a lousy deal for all the countries in the world that are sitting on dollars, or earning negative returns after inflation on low-yield treasury bonds. The more that the U.S. abuses its privileges, in light of the other factors, the more that global demand for dollar-denominated assets — as something to sit with and hold onto — will fall.
None of this is a forecast for the death of the dollar, or for the dollar’s total demise as a popular vehicle in global trade transactions. A change that drastic is not necessary in order for the dollar’s value to fall, by a large amount, over a multi-year period.
This is because the dollar has such a high starting point to fall from. When an asset or a currency is said to be heavily “overweight” in global portfolios, all that is needed is a modest amount of selling — or a sustained shift back toward a “normal” weight — for the value of that asset to potentially fall by a lot.
Remember that the U.S. dollar, as of the second-quarter 2020 tally, comprises more than 61% of global currency reserves. This means that, for every 100 units of cash and government securities that a central bank holds in its reserve accounts, on average more than 61 of those units are U.S. dollar related. (U.S. treasury bonds count in this category, because treasury bonds are directly convertible into dollars.)
Given that state of affairs, imagine what would happen if the dollar’s share of global reserves was cut by a third, falling from, say, just above 61% to somewhere around 40% of reserves.
If that happened, the dollar would still punch far above its weight relative to America’s economic output, and it could still be the most popular reserve currency. But the journey from more than 61% of reserves down to 40% of reserves — as the total number of dollar-based transactions declined — would require a whole lot of dollar-asset selling, on the order of multiple trillions of dollars, over a multi-year period.
And now we get to the heart of the matter as to why the U.S. dollar outlook is historically bearish, quite possibly for the rest of the decade. It is not about an Armageddon call, or an expectation of fiat currency collapse, or even a negative outlook on America’s long-term economic prospects.
Instead, it is more about the transition from a world where a single world reserve currency dominates to an outsized degree, to a world where such dominance is no longer so necessary.
As the world gets a little more comfortable using euros as an alternative commodity-pricing mechanism; storing wealth in Bitcoin; running cross-border transactions less often because ever-more goods and services originate at home; and handling a higher volume of peer-to-peer transactions instantly through blockchain-based settlement systems and payment rails, there will be simply less need for a middle-man transactional vehicle (like the U.S. dollar) that greases the wheels of world trade.
This transition could matter a great deal to traders and investors, even those who never trade currencies or think about them at all.
That is because dollar-based prices are so dominant as a pricing mechanism in today’s world, a sharp long-run decline in the value of the dollar (because central banks are selling off dollar reserves, rather than adding to them) could have a dramatic long-run impact on stock prices, hard asset prices, and more.
Given this state of affairs, a persistent and somewhat extreme one-time journey for the U.S. dollar — going from super-dominant world reserve currency to something still popular, but far less dominant — could be one of those deep, tidal, macro-level influences that impact the price of nearly all other assets for years on end.
And to that end, a falling dollar is bullish for hard assets, and potentially bullish for stock prices, too — at least in nominal terms — because so many things remain priced in dollars, and as a rule, when the value of a currency falls, the value of an asset priced in that currency tends to rise as a natural form of adjustment. If there is a greater supply of dollars available today versus yesterday, those less-valued dollars will buy less of a given asset, and so the dollar-based price of that asset, all other things being equal, goes up.
Adjustments like this tend to happen automatically; if they didn’t, the value of scarce assets (like, say, Google shares) would automatically drop as the value of the pricing currency dropped, and that would not make sense. (If the dollar crashed and saw a 30% decline overnight, would it make sense for the tech juggernauts to also have a 30% off sale, or for gold and oil to have a 30% off sale, just because the dollar was down that much? No — their prices would adjust higher instead.)
The deep and persistent nature of the shifts we are describing — including a major, one-time shift away from the dollar’s multi-decade dominance as the world’s reserve currency — also help explain why we can be deep-conviction dollar bears in terms of expecting the USD downtrend to be long-lasting, playing out not over a period of weeks or months, but years on end (and maybe the rest of the decade). As this trend plays out, it makes sense to expect nominal price appreciation — and in some cases spectacular price appreciation — across a wide range of assets, as much of the stuff that is priced in dollars sees the rubber yardstick of fiat currency value get stretched. In result, a great many excellent trading opportunities should present themselves (indeed this is already happening) along the way.
