The US dollar in the inflation storm
Some would argue that if one examines the evolution of the dollar’s global share as a reserve currency with central banks, its status as a powerful and unique global currency is blurred. Due to rising inflation, it is not at all wrong to think about exchange rates. Differences in inflation between different countries can, after all, be corrected by adjustments between the respective exchange rates. But when investors are, at the same time, nervous about the direction of stocks and bonds, then the latent panic can quickly transfer to the forex market – a market where crises have often taken their first steps.
The dollar’s share as a reserve currency among central banks around the world has declined over the past 25 years. Statistics from the International Monetary Fund show this development every year, so that the dollar now represents about 60% of total reserves, which is the lowest in 25 years. This seems to be one of the arguments supporting the view that the dollar is finally losing ground, but the truth is that 20 years ago the dollar made up about 70% of total central bank reserves. This means that the change in reserves is actually a very slow movement, which affects exchange rates in a limited way.
Another way to put the argument using the dollar as a declining reserve currency into perspective is to compare it to private wealth. Our latest calculation of total global central bank reserves shows about $ 15 trillion in reserves, which is a considerable sum. But if you include estimates from the annual “The World Wealth Report” of the big Swiss bank Credit Suisse, the growth in global wealth alone in 2019 was $ 36 trillion. 2019 has been a sunny year for investors, although the figure only expresses the evolution of global wealth, which must be compared to the total reserves of central banks. I argue that investor investment flows are of much greater importance in the short and long term. I cite this relativization because I have a reservation with respect to certain arguments in the discussion, which are used regarding the direction of the dollar for the remainder of the year, such as the argument with the change in reserves of the central bank.
The market talk is surfacing due to the rapid rise in inflation which has now reached 4.2 percent in the United States. Certainly, high inflation is a threat to a stable currency and an economy with higher inflation will normally have a currency that depreciates with the difference in inflation against other countries. Yet inflation is on the rise all over the world, making it difficult to say that a certain economy, or currency, is particularly at risk due to high inflation.
Part of the current concerns about the dollar are based on very long-term developments, such as the example of central bank reserves. These long-term forces will not give investors any answer on the direction of the dollar for the remainder of this year, and no difference in global inflation will give natural movements between major currencies; leadership during the second half of this year will be caused by other forces.
The global currency market is squeezed because the Chinese renminbi does not float freely. With a weak economy and partially negative interest rates in the eurozone, combined with growing concern about the prospects for the US economy, the result would be a flow of capital to China. Most notably in the past three weeks, this capital flow has occurred, taking the renminbi to three highs against the US dollar. In a floating market, I am convinced that the move would have been much larger as there is a technical reason why the forex markets remain fairly stable. A pragmatic explanation is that investors need breakout opportunities out of the dollar, but the euro is not the most attractive destination, which again results in a stuck situation, rather than free market movements.
Looking at the fundamental reasons why a currency moves, there is evidence that an extraordinarily strong crisis or fear stirs investors, but these two factors do not necessarily lead to the same market reactions. In a severe crisis, investors, companies, etc. will need liquidity to offload assets, and indebted countries will most likely feel the pressure – this could, for example, hurt the dollar. But if investor fear increases and they move towards quality, this could be a supporting factor for the dollar. I expect the crisis and the force of fear to build up, although counterbalancing each other, putting slight pressure on the dollar for the next three months.
Peter Lundgreen is the founding President and CEO of Lundgreen’s Capital. He is a professional investment advisor with over 30 years of experience and a power entrepreneur in investment and finance. Peter is an international columnist and speaker on topics relating to global financial markets.