The Demise of the Dollar?

Last week, Russia announced plans to completely eliminate dollars and dollar-denominated assets from its sovereign wealth fund. Is this another sign of erosion of dollar dominance?

The news from Russia dovetails with a warning by billionaire fund manager Stanley Druckenmiller that the dollar could cease to be the world’s reserve currency within the next 15 years.

Finance Minister Anton Siluanov announced Russia’s $186 billion National Wealth Fund will dump all of its dollar assets during the St. Petersburg International Economic Forum. “Like the central bank, we have decided to reduce investments of the NWF in dollar assets,” he told reporters.

The wealth fund currently holds 35% of its liquid assets in dollars, worth about $41.5 billion. It has roughly the same amount in euros and the rest spread across yuan, gold, yen and pounds. After the reallocation, the fund will hold 40% in euros, 30% in yuan, 20% in gold and 5% each in yen and pounds, according to the finance minister.

This is another move by Russia to minimize its exposure to dollars in an effort to reduce US foreign policy leverage. The Biden administration has hinted at further economic sanctions against Russia in response to hacking allegations. In a research note, an analyst for BlueBay Asset Manager called the announcement “very political.”

The messaging is ‘we don’t need the US. We don’t need to transact in dollars, and we are invulnerable to more US sanctions.”

The United States often uses its privilege as the issuer of the world’s reserve currency as a foreign policy “big stick.” In 2014 and 2015, it blocked several Russian banks from SWIFT as relations between the two countries deteriorated. And in the fall of 2017, the US threatened to lock China out of the dollar system if it didn’t follow UN sanctions on North Korea.

Russia and other countries have made a concerted effort to minimize exposure to the dollar. Even allies such as the EU have created alternate payment channels to circumvent the dollar-based system. We’ve been watching this de-dollarization trend over the last several years, and have written extensively about the push to minimize dollar exposure by countries like Russia and China and their desire to undermine the ability of the US to weaponize the dollar as a foreign policy tool.

Russia in particular has aggressively moved away from dollars in recent years. A report from the Russian central bank earlier this year revealed the country now holds more gold than dollars for the first time ever.

But is this merely the mechanizations of a country having a beef with US foreign policy, or could it hint at a bigger threat to dollar dominance?

The Financial Times published an article last week headlined, “The Demise of the Dollar? Reserve Currencies in the Era of ‘Going Big’.” The article warns, “The extraordinary stimulus measures in the US could undermine confidence in the greenback if inflation takes off.”

The article quotes Druckenmiller, who said, “I can’t find any period in history where monetary and fiscal policy were this out of step with the economic circumstances.”

You could argue Druckenmiller is engaging in hyperbole, but there has definitely been a slide in dollar dominance over the last few years. It’s not just the Russians. Many central banks have dumped dollars.

The IMF’s latest survey of official foreign exchange reserves shows that the share of US dollar reserves held by central banks fell to 59% during the fourth quarter of 2020. When the euro launched in 1999, 71% of global reserves were held in dollars.

De-dollarization could accelerate if the world loses faith in US government policy. The Financial Times article warns that the unprecedented levels of deficit spending and the rampant Federal Reserve money printing necessary to monetize the debt threaten the stability of the dollar.

There is general agreement that the biggest single peacetime threat to reserve currency status is economic and financial mismanagement. And with the Federal Reserve having abandoned its longstanding commitment to tightening policy in anticipation of inflation and President Joe Biden ‘going big’ with fiscal policy, the fear that inflation could undermine the currency is mounting.”

The article goes on to say, “The anti-inflationary credibility won at such high cost by the Fed over the past 40 years may now be in question, causing foreign investors to worry that the US will inflate away the value of their Treasury holdings.”

The FT raises the operative question: “Are there circumstances in which what still amounts to dollar dominance suddenly could turn into a dollar rout?”

Turbulence in the Treasury market in March 2020 also has global investors on edge.

As the pandemic gripped the world, we saw a typical move into the “safety” of US bonds. But beginning around March 9, 2020, there was what the Financial Times called “a disorderly flight from Treasury paper into cash.”

Analysis by the Basel-based Bank for International Settlements has shown that the dash for cash resulted substantially from forced selling by hedge funds that had borrowed heavily to profit from small differences in yield between cash Treasuries and the corresponding Treasury futures.

“With the downward lunge in the market, the solvency of these highly leveraged funds was threatened and their lenders called in their loans, forcing the hedge funds to sell. In effect a feedback loop developed in which the inability of dealers to absorb sales led to further price declines, prompting more sales and leading to further price declines. Dealers responded by widening the bid-ask spreads they offered their clients on average by a factor of 13 in the first weeks of March. That should not have happened in what is usually termed the world’s deepest, most liquid government bond market.”

This reveals structural cracks in the bond market and it lends support to those who argue that the Fed is limited in its ability to tighten monetary policy. If the US government plans to continue borrowing and spending at this level  – and based on Biden’s 2022 budget, it clearly does – the central bank will have to continue intervening in the Treasury market in order to keep it stable. There simply isn’t enough demand in the market for all of these government bonds. Keep in mind that the Fed bought more than half the total Treasuries sold from March 2020 to the present.

That means more inflation. And as the Financial Times put it, inflation is “the greatest potential threat to safety.”

Does this mean we’re predicting the imminent demise of the dollar? Not necessarily. In a lot of ways, this looks more like a slow burn than an impending explosion. But given enough time, a slow burn will destroy a building every bit as much as a sudden detonation.

Looking ahead, the question becomes do you believe that the US will substantively shift policy? Will Biden roll back the spending? Will the Fed really tighten monetary policy and stop printing money?

If not, the dollar could be in trouble.