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In all the anguish over the recent decline of the dollar, two simple facts seem to have become misplaced.

  1. A very large amount of the day to day positions in the currency markets and thus the negative movement in the dollar is the result of traders chasing profits. It is obvious but worthwhile to state again that these are trading markets and trading markets are all about trading profits. Currency markets are not designed, at least in their day to day valuation, to make judgments about the viability of a currency’s reserve status.
  2. As soon as the Fed signals that its easy money policy is at an end a great percentage of those traders who are now avid dollar shorts will reverse and become with equal sincerity dollar longs. New punters who see profit potential in long dollar positions will soon join the ex-shorts as the Fed begins a rate cycle that might last two years and bring the Fed Funds rate back to historical norms. The dollar will follow the funds rate higher.

The world’s disenchantment with the dollar as reserve currency is new. Only eight months ago the dollar was all the rage. The world fled to the dollar and dollar assets as global financial markets imploded. If another crisis struck tomorrow it is unlikely that the world seek financial refuge in a different national script and government? The current trading equation of risk and reward is a dollar based concept; as risk rises so does the value of the dollar. This logic remains true. If this aspect of the dollar’s place in the world economic system has not really changed what then are the motivations and logic of the critics of the dollar’s reserve status?

There are four different complaints about the dollar’s reserve status. The first two are topical, that is they offer the critics a convenient way to advance their own political but not necessarily financial plans; the second two are substantive. That is they raise issues that over time could and probably will diminish dollar’s reserve role in the world economy.

  1. The dollar offers substantial benefits to the US Government by allowing it to fund its deficits in its own currency. This provides the Federal Government with a fiscal support that gives its political agenda a much wider reach than if Washington had to depend solely on its own resources. For political adversaries, curtailing the dollar’s reserve role would limit American freedom of international action. A country that cannot pay for its endeavors must choose between its commitments. How long will China pay for the US Navy’s Pacific Fleet to patrol the Taiwan Strait?
  2. Dollar resentment is recent and it is much closer tied to the decline of the currency since March than any realistic change its reserve status. Where were the complainers when the dollar was rising from July to March?
  3. US Federal deficits, real and projected, are a new and damaging entry in the reserve equation. How long will America’s competitors continue to lend Washington money? The answer is straightforward—as long as it is in their interest to do so and no longer.
  4. The creation of the Euro and its performance in this crisis has focused the minds of the world’s money managers and bankers—there is an alternative to the dollar. Though the euro has drawbacks as a reserve currency, primarily its fragmented and limited bond markets, its efficiency as a medium of exchange and its ability to retain value as defended by the European Central Bank are real and strong.

None of this means that the dollar is not gradually weakening and that it may be replaced or at least supplemented as the world’s reserve currency.

But we must be careful to differentiate between short term positioning in the currency markets that will likely be reversed by a change in Fed policy, and the long term and gradual trend down in the dollar as world reserve currency. Indeed the term itself is misnomer. There is no reserve currency created by a global bank and backed but its reserves. The dollar is the world’s most common medium of exchange and store of value because it has evolved into that role. For most of the past half century the American economy dominated world finances and trade. The ascendancy of the dollar is a product of that position in the global economy. That dominance has been slipping for at least a generation, since the first Arab oil embargo, but over the past decade it has become increasingly obvious.

The question for currency traders is not will the Fed engineer a recovery in the dollar when it begins to increase interest rates and will that quiet doubts about the dollar’s reserve role. The Fed can and the doubts will recede.

The question is how far will the dollar fall before this happens and will that fall have permanently damaged the world’s faith in its reserve currency?

Source: The Dollar Coin: Two Sides of the Reserve Dollar