King Dollar in Trouble of Being Dethroned

It is widely understood that the U.S. dollar is the world’s reserve currency, primarily because of its stability and acceptance in international trade.

The Bretton Woods Agreement of 1944 formalized the U.S. dollar’s status as the world’s reserve currency, backed by the largest gold reserves. The dollar was officially de-pegged from gold on August 15, 1971, by President Nixon in a series of economic measures known as the Nixon Shock.

The de-pegging was done in response to rising inflation and a soaring trade deficit, which made it increasingly difficult to maintain the gold standard. From that time to today, the dollar has traded as a fiat currency, meaning its value is not backed by any physical commodity, but instead trades on the “full faith and credit” of the U.S. Treasury, and has continued to hold the mantle of the worlds reserve currency based on trust.

Several other countries seeking stability in their sovereign currencies have pegged their exchange rates to the dollar, with much of the global financial system dependent on the stability of the dollar for the smooth free flow of international trade. In fact, most crude oil transactions are done so in U.S. dollars despite the efforts of China to undermine this standard of global oil trading.

After the United States abandoned the gold standard the U.S. Federal Reserve, the U.S. dollar index (DXY) was established as a measure of the value of the U.S. dollar relative to a basket of foreign currencies. These are: the euro, Swiss franc, Japanese yen, Canadian dollar, British pound and Swedish krona. The euro is, by far, the largest component of the index, making up 57.6% of the basket. The weights of the rest of the currencies in the index are the Japanese yen (13.6%), British pound (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%) and Swiss franc (3.6%).

The history of the dollar index (DXY) going back to 1973 has shown a path of relative stability with the exception of the major spike in the 1984-1985 period. Big increases in government spending to revive the economy back then drove up long-term interest rates, thereby attracting capital inflows which, in turn, pushed up the value of the dollar as dollar-denominated Treasuries were highly desirable. This condition mirrors the past two years, where trillions of dollars in government spending, coupled with 11 consecutive Fed rate hikes, provided a strong bid for the dollar, right up until the Fed’s recent pivot on monetary policy by its leaders jawboning about cutting rates in 2024.

Going back to early October 2023, bond traders started sniffing out that the Fed was about to change the narrative as inflation data cooled. And they were right. Treasury yields on the long end of the curve have plunged a full 125-basis points since then. When bond yields decrease, the value of the underlying currency tends to decrease as well, especially when factoring in more than $31 trillion in national debt that must be serviced. This is the potential game changer for the dollar going forward.

In the past two months, the DXY has traded from 115.0 to 101.2, representing a big devaluation against the basket of currencies noted. The quandary for the Fed is that it needs to have interest rates at exceptionally low levels to service the soaring interest on the federal debt. At the same time, in doing so, currency traders will likely pressure the dollar lower until there is conviction at the Congressional level to tackle the budget deficit and the long-term debt balloon.

This is a problematic scenario in the making that must be addressed. If the world begins to lose faith in the ability of the United States to resolve its debt burden, the value of the dollar will break down, forcing bond yields higher to attract capital at the Treasury auctions to finance current spending and debt services. It’s a monumental problem that has been in the making for years and is now approaching an inflection point with rates expected to come down in the year ahead.

While there is no other currency that can realistically replace king dollar, there is much consternation about where to find safety from fiat currencies that are losing value because central banks of developed countries binged on quantitative easing and now sit on tens of trillions of dollars in debt with little to no realistic plans to pay down the debt anytime soon. Hence, the value of the euro, Japan’s yen, Britain’s pound sterling and Canada’s loonie are also in protracted downtrends. So, where is the safe zone?

The Swiss franc. With a debt-to-GDP of only 41%, Switzerland has one of the lowest debt levels to its national revenues of any developed country in the world. Plus, Swiss accounts have always been a storehouse of wealth over generations of global financial upheaval and wars. Shares of the Invesco Currency Shares Swiss Franc Trust ETF (FXF) are, in my view, a strong place to own Swiss francs in the form of an ETF without having to store the physical currency in a safe or safety deposit box at a bank.

The bullish move of late by FXF shares is a strong indicator of where money is flowing to offset the devaluation of the dollar. Unless the 2024 U.S. election year reveals a new attitude and conviction to address the debt bomb facing the country, owning FXF could be one of the bigger winning trades of 2024 and well beyond.

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