Over the last few months, we’ve been working with Jeff Snider of Alhambra Investments (the guy who knows more about the monetary system than Keith Gill does about trolling Congress) to bring you last month’s Eurodollar Market Primer, which sets the foundation for this week’s piece, Jeff’s view on the US Dollar.
Before diving into this one, we highly suggest you go give the Eurodollar Market Primer a read, as it sheds light on this shadow market, which is not only grossly misunderstood but is also part of the bedrock on which Jeff’s dollar thesis is built.
A reserve currency first and foremost must be an intermediary; it must translate a common set of circumstances in order for global integration to occur. A more closely connected global economy maximizes efficiency and promotes the modern “miracle” of sustained increases in living standards for those joining the common framework.
It’s estimated that half of all global trade is directly invoiced in US Dollars even though American trade only accounts for about 12% of all activity. In terms of financial flows, upwards of 90% of the more complex “capital” flows originate through US Dollar accounts or derivatives.
For lack of a better term, it’s the “middle currency” through which very disparate systems, most of which are located on opposite ends of the world, can easily transact one with the other.
Without this ‘middle currency’, global trade and financial flows aren’t impossible but become more difficult. Where efficiency ultimately determines the level of success, a reserve currency will be introduced regardless of any public sector intent or involvement. Meaning, even if a government doesn’t create a monetary system, money will happen, as ‘nature finds a way’. (Yes, that’s an obscure Jeff Goldblum quote from Jurassic Park…you’re welcome). More accurately, even if a government does create a monetary system, if it’s not sufficiently efficient (as we’ll see below), a new one will be created. ‘The market finds a way’.
The ultimate dissolution of the global currency regime under 1944’s Bretton Woods took place earlier than is commonly understood. While US President Richard Nixon took action in August 1971 to close down foreign convertibility demanding US stores of gold reserves, as far back as the middle 1950’s the Eurodollar Market had already absorbed most of the technical power required for the end of monetary operation. Simply put, 1971 was more the ‘academic’ end of the previous monetary system, but the ‘functional’ end had taken place more than a decade earlier with the rise of the Eurodollar market.
As a reserve-less virtual system, this eurodollar standard had easily met Robert Solomon’s “three pillars” required for reserve currency function:
Whilst the Eurodollar was (and sometimes still is) successful at all three, the US Dollar failed one and two.
The Eurodollar system, which piggybacks on its US dollar denomination (solving for confidence), could more easily and readily respond to the dynamic needs (adjustment) of a technologically evolving and integrated economy (read the Eurodollar Market Primer for more details on this). And because banks stood to make large profits from participating in this global eurodollar money dealing and are constrained only by their own balance sheet considerations, the system had – most times – assured widespread availability (liquidity) of monetary resources.
Contrary to most conventional beliefs, the 2008 Global Financial Crisis (GFC1) was not a one-off nor temporary dollar shortage. Beginning August 9, 2007, this shadow eurodollar reserve fractured and then devolved into what appears to be a permanent state of generalized difficulties.
Briefly, the banking systems balance sheet constraints had to be reconciled to previously misidentified and misunderstood risks (including what the role of any central bank truly is and isn’t capable of) which acted as a cap on banks’ ability to be agile with their balance sheets. Simply put, the system was already unstable but had never truly been tested until GFC1. The mortgage crisis acted as the first domino to fall, exposing an already fractured system, that continues today.
The result of this constraint has been periods marked by specific acuteness in both the liquidity and adjustment reserve functions; GFC1 was a global dollar liquidity shortage. As the mortgage crisis grew, banks were forced to liquidate assets to acquire more dollars to cover losses, and eventually the world needed more dollars than were available. Thus, a dollar shortage ensued and metastasized throughout the monetary system. In terms of the dollar’s exchange value, it rose quickly and substantially against most other currencies – one tell-tale sign of this shortage.
While it had been expected to resume its downward pre-crisis baseline in light of the Fed’s “money printing” and “excesses” undertaken under the banner of “quantitative easing”, instead the dollar has, over the long run, generally moved upward.
The long-run dollar shortage trend is the current monetary state we live in, where global economic growth is outpacing the supply of the global reserve currency. Hence, we’re net short the dollars required to run our interconnected global economy, which helps strengthen the US Dollar against other non-reserve currencies in the long term.
The upward trend in the dollar’s exchange value (a structural global dollar shortage) is broken at times by reflationary conditions best described as false dawns. Following acute shortage sequences (like GFC1), the bank-centered system shifts from an extreme shortage to a relaxation of that shortage reducing the negative pressures upon the liquidity and adjustment functions; but only to a relative degree.
During these intermittent reflationary periods, the dollar’s exchange price will likewise “relax”; that is, it will decline somewhat and only relative to its more extreme values set during the worst part of each shortage. This is each time mistaken for the long-predicted “currency debasement”, supposedly the eventual consequence of central bank (particularly the Fed’s) “money printing”.
However, since it is, again, merely the reflationary intermission between the short-run acute phases of the overall permanent shortage, the dollar’s “crash” fails to materialize, and over time, instead, the exchange value moves even higher as the next shortage in the sequence begins to dominate global conditions.
GFC2 was triggered by COVID in March 2020, which again pushed the exchange value to an even greater extreme, representing the most acute, and most uniformly spread, global dollar shortage since GFC1. Since then, particularly with the global economy reopening in May 2020, the dollar’s exchange value has once again declined relative to its prior maximum indicating relaxation of the shortage.
The fact that the dollar hasn’t fallen very far or very fast is another key signal of reflation rather than categorical change towards central bank-inspired debasement. This is corroborated in related markets (UST yields, global sovereigns, money curves, etc.) which means that in the short run the path of least resistance continues to be more relaxation/reflation if only until the next trigger causing a shortage.
What determines the boundary between reflation and the acute shortage is complex and it has been different at each interval over the past thirteen years; in broad terms, it is the general perception of risk in the banking (therefore monetary) system which renews balance sheet constraints (they come and go across cycles, and in a shortage environment they are once again put back in place), hampering adjustment and liquidity functions leading to self-reinforcing feedbacks.
When this takes place, we expect to see the dollar “catch a bid” when hardly anyone expects it, confirmed by increased risk aversion in the global money dealing space, particularly as it relates to repo/derivative collateral reflected in higher UST and related prices (read the Eurodollar Market Primer for more details on this).
This back and forth between dollar shortage and temporarily relaxing dollar (i.e. increased liquidity) will continue to drive the US Dollar up in the long-term with some short-term corrections until something meaningful changes in the global reserve currency regime.
Given that officials – let alone the public – are much aware of these monetary problems in the framework, it’s very unlikely the sort of changes required to pull out of the overall, long-run shortage trend will take place. In Jeff Snider’s words, “we’d just need to re-write the whole script”.
In 2017, it was widely declared that “globally synchronized growth” represented the categorical shift from the post-GFC1 economy into an inflationary and accelerating ‘real’ recovery. Nearly all economies around the world were producing positive GDP results at the same time for the first time since before GFC1, and official central bank predictions declared that monetary policy (QE) had finally been effective; they just needed time.
Therefore, the combination of global recovery from the 2015-16 downturn plus a few more years of extreme monetary (and fiscal) policy led to mainstream projections of rising consumer prices across the developed and emerging world. This inflationary acceleration would have been the key piece of evidence that this categorical change out of the post-2008 malaise had been finally achieved. There would now be a ‘real’ recovery.
Additionally, predictions for higher interest rates worldwide, as well as the falling dollar, were consistent with more inflationary growth in the US system. Even bitcoin was hugely bid as “protection” against globally synchronized growth perhaps getting out of control (a dollar crash scenario). This reminds us of today’s narrative…
To ensure a smooth transition into the post-crisis recovery, central banks began to remove their prior “accommodative” stances, most notably the ECB ending QE in late 2018 while the Federal Reserve engaged in “rate hikes” while calling for a more aggressive “tightening” moving into 2019.
Instead, right from the outset of 2018, Euro$ #4 (in the graphs below), which quickly knocked globally synchronized growth into an increasingly synchronized global downturn, was incorrectly attributed to “trade wars”. This predictable economic reverse took hold first in China, Germany, and Japan before spreading to cover nearly all the rest of the global economy long before COVID.
By the end of 2019, Japan, Europe, and other parts of the world were already experiencing a mild recession (the US on the verge) which left them even more susceptible to the COVID shock.
In other words, the introduction of the most recent global dollar shortage (Euro$ #4) had completely erased the inflationary growth called for in mainstream forecasts; a rising dollar (beginning back in April 2018), instead priced the same disinflationary/deflationary downturn as this, rather than recovery, registered across more of the global economy.
A restrictive global reserve currency (less liquidity, more difficult adjustment, erosion in confidence)
Plentiful Eurodollars before Euro$ #1 had meant the accumulation of these “dollars” (bank liabilities) concentrated in central banks’ hands. Converted into “reserve assets”, particularly USTs, overseas central bank balance sheets had come to depend upon reserve assets to underpin domestic monetary growth
Without these “dollars” coming in, particularly during each global dollar shortage, foreign central banks have to mobilize their “reserve assets”. This means that they must sell their USTs in order to supply dollars that the Eurodollar market can’t or won’t, which has the unintended side effect of shrinking the domestic monetary base, further constraining the local economy.
Across all these channels, the net result is a global downturn/recession initiated and sustained by the renewal of the acute global dollar shortage.
The following charts illustrate these dollar shortage / reflationary cycles through the lens of various economic indicators, all telling the same story:
Looking ahead to 2021, a renewed acute dollar shortage would cause the same kinds of negative global economic pressures already witnessed repeatedly in markets, economic data, and the failed inflationary responses of QE four times already over the last thirteen years.
The contrary dollar shortage case is relatively simple; not only would the dollar’s exchange value have to decline more significantly (and more than just against the euro and British pound), but we would also need to see global bond conditions corroborate the underlying shift. Meaning, not just slightly rising nominal yields, as has been consistent with only reflationary interims, but dramatic moves featuring dynamic changes in bond and money curves way beyond the cursory fluctuations witnessed so far since March 2020 extremes.
The global economy would then have to follow, meaning that instead of the meandering rebound we’ve seen since early last year, we’d expect an unambiguous acceleration across all fronts (the definition of recovery). If past reflation is and has been correctly characterized by the slight and arguable appearance of the first stages of some of these things, an end to the reflation/shortage cycles would be obvious and evident to everyone with only minor outliers in markets, or data.
If the underlying balance sheet constraints, which have produced this baseline global dollar shortage, have been successfully removed for the first time, then it’d be the banking system where we’d expect to find perfectly apparent and clear risk-taking (i.e. balance sheet expansion) activities.