U.S. Dollar: Structural Weakness

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Includes: UDN, USDU, UUP
by: Simon-Peter Noble
Summary

This article makes the argument that the US dollar will decline over the medium to long term.

Drivers for medium-term decline include unsustainable federal debt, exacerbated by large fiscal deficits.

The driver for long-term decline is less dollar demand as other countries internationalize their currencies.

The inductive argument

Premise 1: Federal debt-to-GDP is large and growing which will increase future risk perceptions and reduce dollar (UDN) demand.

Premise 2: The fiscal deficit is large and structurally unsustainable which will also increase future risk perceptions and reduce dollar demand.

Premise 3: Net dollar demand will decrease as emerging countries internationalize their currencies.

Conclusion: The US Dollar will weaken over the medium to long term.

Premise 1: Federal debt-to-GDP is large and growing which will increase future risk perceptions and reduce dollar demand.

Federal debt-to-GDP is approaching levels not seen since World War 2. The debt ratio will continue growing because fiscal deficits structurally exceed potential GDP growth. America’s long-run real potential growth rate is approximately 2 percent per annum whilst projected budget deficits are minus 4.8 percent, largely linked to growing Social Security and Medicare expenditure. The recent spike in real GDP was from pro-cyclical fiscal stimulus that isn’t sustainable.

At some point, the broader market will realize that options for the debt include: default, inflating it away, or austerity which would breed more populism. Either scenario will raise risk perceptions and decrease dollar demand.

Premise 2: The fiscal deficit is large and structurally unsustainable which will increase future risk perceptions and reduce dollar demand

The US government has been living beyond its means for a long time. The Keynesian notion of surpluses during expansions and deficits during recessions has been replaced by permanent and large deficits.

Projected deficits are exacerbated by an ageing population which requires more funds for Medicare and Social Security.

Risk perceptions will rise when the market sees the status quo as unsustainable. Increased risk perceptions will demand higher long-term interest rates, this will create higher net interest projections and raise even more fears about the sustainability of US government finances. Dollar demand should inevitably decline in such an environment as the sustainability of government finances becomes the market’s focus. Painful decisions will have to be made by Congress which reduce spending and raise taxes. Both options will reduce GDP growth and potentially fuel populism that could further damage risk perceptions and reduce dollar demand.

Premise 3: Net dollar demand will decrease as emerging countries internationalize their currencies.

Currently, there’s no evidence for central bank reserves moving away from the dollar. The dollar retains approximately 60% of the $11.4 trillion reserve market.

But the dollar’s dominance of international payments has weakened over the last two years.

It’s unclear whether this is a cyclical movement or a broader trend away from the currency as countries served or threatened with US sanctions have rotated to the euro.

Ignoring the geopolitics, just as the US promoted dollar usage in the 1920s for trade acceptances, China, India and other emerging nations will promote the international usage of their own currencies because it will benefit their economic development and financial systems if implemented correctly. The dollar’s dominance is an anomalistic legacy from World War 2, Bretton Woods, and incumbency.

As emerging countries continue to grow, it’s inevitable that the share of international payments will trend towards nominal trade activity, albeit very slowly as detailed by China’s lack of progress in the chart above. Eventually, this will result in less net dollar demand as domestic currencies won’t have to be sold for US dollars and central banks will retain less US dollars for reserves to align with their trade flows.

Conclusion

I think it’s inevitable that the dollar will decline over the medium term because the US government is financially irresponsible. Large fiscal deficits that increase federal debt-to-GDP are unsustainable and the marketplace should reach this conclusion over the medium term, reducing demand for the currency. Over the long term, the dollar’s role as an international currency should decline as emerging countries internationalize their own currencies.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.