Long Live the Dollar!

Amid increasing levels of geopolitical instability and inflation, pressure on the Federal Reserve to deliver relief is intensifying and speculation about the U.S. dollar (USD) losing its status as the world’s preeminent currency is rising.

Why does this matter? Holding this reserve status confers some substantial benefits on the issuing country:(1)

• Lower interest rates and borrowing costs, as global demand for that government’s bonds is generally resilient and high 
• Reduced transaction costs and exchange rate risk for trade (especially commodities, as they are generally settled in dollars)
• Significantly reduced default risk on national debt, since the country that issues the reserve currency can more easily borrow in the home currency
• Enhanced insulation from global economic turbulence
• Greater influence in support of geopolitical objectives

The role of the USD as the dominant global currency has stood unchallenged for many decades, accounting for nearly half of all cross-border banking and international bond market activity.  But there is no guarantee that the USD will always be the dominant global currency. The U.S. inherited the mantle from the British (1920s), the British took it from the French (18th Century), the French took it from the Dutch (17th Century), and the Dutch took it from the Spanish (16th Century).(2) At some point, another country could take this privilege away from the U.S.

In fact, the growth and development of other international economies and monetary units (such as the Chinese Renminbi/Yuan and the Euro) has led USD antagonists to predict it will lose its position as the global reserve currency. To bolster their case, they point to a steady decline in the percentage of global FOREX (foreign currency) reserves allocated to the USD.(3)

While this is indeed an observable trend, we believe they are ignoring several qualitative factors that make the USD nearly impossible to overtake now:

• Size: It is simply impossible for any other existing unit of monetary value to replicate the dollar reserve system. The sheer amount of dollar denominated assets, international debt, and foreign exchange holdings in central banks around the world is considerably larger than any other currency. For comparison’s sake, the Bank of International Settlement’s global liquidity indicator reported that as of June 2022, dollar-denominated assets in global banks were around $78 trillion – more than double the Euro and nearly four times the Yen!(4) Accordingly, in order for another currency to balance this gaping disparity, banks would have to scale up their balance sheets by tens of trillions of dollars, which simply isn’t feasible while also maintaining a stable and well-structured balance sheet. 
• The Fed’s History: Because of the central role of the USD in international finance, global economic and financial activity is highly dependent on the ability of USD funding to flow smoothly and efficiently between users. This means the global economy is dependent on the Federal Reserve’s ability to operate smoothly, and no other central bank has either the capacity or credibility to intervene at such scale. The Federal Reserve has been able to intervene and keep liquidity flowing in times of crisis, which has inspired confidence and trust in their ability to do it when needed the next time. It kept financial systems afloat in 2008 during the Great Financial Crisis, and again in mid-2020 when global economies collapsed as a result of the pandemic.  Global banking systems now rely on the Federal Reserve and USD to accommodate such periods of stress, which demonstrates a level of trust that cannot be easily replicated by other such authorities.
• Necessary Framework: In order to be accepted as a reserve globally, a currency regime has to exhibit a few key characteristics, the most important of which are allowing money to flow freely in and out of the country and having an independent and effective monetary policy. Let’s look at the two biggest contenders, the Euro Zone and China, and assess their ability to meet these requirements:
  • The European Central Bank, and by extension the Euro, has many concerns as they continue to manage the inherent instability of the fractured economies, policies, and beliefs that underly their collective monetary union. The U.S. has achieved an envious position of homogeneity, whereas a union of disparate countries has proven to be much more difficult to accomplish. Furthermore, Euro holdings are simply too small relative to the USD globally (refer to Size, above).
  • China, alternatively, has even greater structural problems in terms of functioning as a global currency provider. The transparency of Chinese markets leaves much to be desired, and if the world’s banks are going to hold a currency as a form of stability, this lack of trust obviously impairs that ability. Furthermore, the Chinese Communist Party (CCP) would have to be willing to open their borders in terms of monetary flows, meaning they could no longer control how capital moves into and out of the country. This would compromise their ability to exercise control over the Chinese currency system and economy, and run directly counter to their historical practice of actively manipulating (devaluing) their currency to gain an unfair advantage in international trade.(5) Lastly, and perhaps most prohibitively, China would have to be willing to run persistent deficits to fund their spending needs – you simply cannot expect the world to hold sufficient levels of your debt if you don’t issue enough of it to fill bank coffers in the first place. Currently, the Chinese government’s stated strategy for economic growth focuses exclusively on maintaining a trade surplus, rendering this final roadblock insurmountable absent a complete pivot in policy.  
• Safety: Due to the size and relative stability of the U.S. economy, the USD is widely considered the dominant “safe haven” currency. This means that during times of global instability and market turbulence (such as has been triggered by the Russian invasion of Ukraine), investors around the world pile into the USD. This extends not only to outright USD holdings, but also to U.S. Treasury issued bonds (T-bills). These assets being backed by the “full faith and credit of the U.S. government” instills confidence in investors that their holdings will remain relatively safe and secure regardless of global volatility.

Summary

To be a worthy global reserve, a currency requires that:

1. Other nations trust in the issuing central bank’s monetary policy (i.e., it is effective and transparent)
2. There be enough of the currency in circulation to meet regulatory and transactional needs
3. Everyone involved is fully willing to accept this currency as payment for trade and financing
4. It is considered a “safe” currency to hold long-term

Currently, only the USD can fill this role. And the longer the USD maintains its position as the global reserve currency of choice, the harder it will be for other currencies to take its place. Because of this status quo, and for all of the other reasons detailed in this commentary, we don’t expect any legitimate challenge to the USD for the foreseeable future.  As U.S. based investors, that means we can remain confident in the banking system and in the safety of our deposits, knowing that the full faith and credit of the USD will continue to reign supreme during both good and bad times.

As always, if you have questions or concerns about the markets, or just want to ensure that your portfolio is properly aligned with your circumstances, goals, and tolerance for risk, reach out to your Financial Advisor. Being confident in your plan is the key to successfully navigating your financial journey.

The information in this report was prepared by John Weitzer, Chief Investment Officer, Matt Wiley, Director Investment Management, and Matt Conner, Investment Advisory Consultant of First Command. Opinions represent First Command’s opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual advisor. All statistics quoted are as of the date of this publication, unless otherwise noted. First Command does not undertake to advise you of any change in its opinions or the information contained in this report. This report is not intended to be a client specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Should you require investment advice, please consult with your financial advisor. Risk is inherent in the market. Past performance does not guarantee future results. Your investment may be worth more or less than its original cost. Your investment returns will be affected by investment expenses, fees, taxes and other costs.

©2022 First Command Financial Services, Inc. is the parent company of First Command Brokerage Services, Inc. (Member SIPC, FINRA), First Command Advisory Services, Inc. Securities products and brokerage services are provided by First Command Brokerage Services, Inc., a broker-dealer. Financial planning and investment advisory services are offered by First Command Advisory Services, Inc., an investment adviser. A financial plan, by itself, cannot assure that retirement or other financial goals will be met. Actual results, performance, or achievements may differ materially from any future results, performance, or achievements expressed or implied herein. Over a longer time horizon, equity markets historically exhibit higher highs and higher lows, and thus bull markets have created more wealth than corrections and bear markets have destroyed – if you stay fully invested in accordance with a financial plan.

Footnotes

1. Eichengreen, B., Mehl, A., & Chitu, L. (2017). Mars or Mercury? The Geopolitics of International Currency Choice. NBER Working Paper Series.
2. Eichengreen, B. (2015). International Currencies Past, Present and Future: Two Views from Economic History. BOK Working Paper Series.
3. IMF – Currency Composition of Official Foreign Exchange Reserves, June 2022.
4. IMF – Currency Composition of Official Foreign Exchange Reserves, June 2022.
5. US Department of the Treasury – Macroeconomic and Foreign Exchange Policies of Major Training Partners of the United States – May 2019.