One of the questions that’s come up a lot this year as the financial markets process the implications of the trade war is whether the dollar is either losing, or in danger of losing, its status as the reserve currency of the world.
And those questions really came to the fore in April because we saw the exchange value of the dollar go down, the price of treasury bonds go down—meaning the yields went up—and US equity markets go down, all at the same time. And that sort of simultaneous sell-off is pretty unusual. And it certainly looks, at least circumstantially, as though it might be attributable to reserve managers around the world reducing their dollar holdings and reducing their holdings of dollar-based assets.
I would caution here that we don’t get very good data on reserve flows in real time. So at best, this is a circumstantial case rather than one that we can prove. But it does force market participants to contemplate the scenario of the dollar losing stature around the world.
Denting Dollar Demand
A big part of the reason the dollar has been the world’s reserve currency is because US economic policy has been predictable, has been process oriented, and has been rules based. And right now, all three of those are sort of up in the air. And so it is clear, I think, that reserve managers around the world have an incentive to try to diversify away from the dollar.
For what it’s worth, I think that the US administration might welcome that, not because they want the dollar’s role in financial transactions or in the global economy to diminish but because a weaker dollar, which is what would likely result if reserve flows are reallocated, would help fulfill the administration’s objectives of reducing the US dollar’s trade deficit.
One of the clear implications if reserve flows reallocate is that interest rates are likely to be higher than they otherwise would be, for two reasons. One is that a weaker dollar would likely push inflation somewhat higher. But more significantly, large portions of dollar assets held by reserve managers are held in Treasuries. And if they were to reduce their holdings of Treasuries, that would also push interest rates higher.
If Not the Dollar, Then What?
The challenge, of course, is that it’s not clear what the alternative asset to the dollar is. There isn’t another currency that serves the same role in the global economy. Most other currencies are not as freely traded or are not as liquid. The economies on which they are based are not as large.
That makes us a little bit skeptical that we are seeing a dramatic reallocation of foreign exchange reserves. That said, it’s very possible we are seeing movement around the margins, and that changes in US policy are providing enough of an incentive to force reserve managers to look elsewhere. Certainly, we’ve seen appreciation in the euro that goes beyond what its cyclical fundamentals would dictate. There’s been a large increase in the price of gold.
We’re not ready to conclude yet that the dollar’s day in the sun is done, but it is something that we’ll have to monitor in the months going forward.