The Dollar: Half Awake in a Fake Empire?

What You Need to Know

The dollar is now less of a safe haven and investors should respond accordingly. Having said that, the lack of any viable alternative means that a shift away from the dollar is likely to be slow rather than sudden. Indeed, despite all the angst and column inches, there is zero evidence of significant outflows from US assets so far.

There are distinct reasons for the dollar being more risky: fiscal sustainability questions, geopolitics and capricious policy making. Given this range of forces that all point in the same direction, we think that the dollar’s reserve status will indeed be eroded and that the process of de-dollarization is set to last, albeit at a slow pace. The lack of a liquid alternative is the dollar’s strongest support.

The fiscal concerns are, to some extent, shared with G7 economies, and the interplay of sovereign risk and demand for liquid assets is complex and highly uncertain. After all, there is no level of debt/gross domestic product (GDP) that constitutes a hard limit.

The geopolitical aspect of the dollar is an inescapable part of forming a view. This process also encompasses central bank digital currencies (CBDCs) and the evolution in the nature of money. To that end, this note also includes a book-review section covering recent important publications in this field (these works might also be of use for those seeking topical beach reading this summer).

We analyse strategic currency hedging in multi-asset portfolios and show how the benefits vary for investors in different regions. We suggest how this should adapt given the changing risks of dollar exposure.

Additional Contributors: Alla Harmsworth, Robertas Stancikas, Harjaspreet Mand and Maureen Hughes

Sometimes questions from investors coalesce around a topic in such a dominant way that it is very easy to determine what our next note should be about. At the moment that issue is the US dollar, its role and the prognosis for its future. A lot of the focus in financial commentary is on whether the dollar’s recent deprecation will continue (the consensus seems to suggest that it will). We agree with that view, but we also want to link this to the riskiness of the dollar, as opposed to just its direction. A discussion of the dollar also requires addressing bigger topics such as geopolitics, the new cold war and the meaning of reserve-currency status.

We have addressed related issues in recent notes to tackle the topic of US assets and bigger shifts in the nature of money:

Our recent note on US exceptionalism robustly defends the case for a strategic overweight of US equities.

We also recently addressed the question of trust in US assets and the extent to which this may have seen a permanent impairment as a result of capricious policymaking and suggestions of forcible conversion of foreign holdings of US bonds.

We have also recently discussed the role of tokenization and the social role of money and the future of work.

This note focuses on the dollar specifically. We start outlining recent changes in dollar behavior and whether there is a sign of a real movement out of dollar assets. We review threats to reserve currency status, which necessarily touches on deeper questions such as: What is money? We review several recent significant books that address these big picture questions of currency. We conclude with the implications for portfolios and what it means for the need to hedge dollar exposure.

The conclusion we reach is that there are three distinct threats to the dollar’s status: worries about fiscal sustainability, geopolitics and domestic policy choices. Some of these concerns, e.g. fiscal worries, apply to other economies too; for others, such as geopolitics, timing is very hard to determine and is bound up in the changing global role of the US. Set against this is the lack of desirable alternatives, which tempers the likelihood of abrupt changes. Nevertheless, with such different forces in place, investors who continue to use the same rules of thumb about the dollar are at risk of being only half awake to multiple changes taking place in different spheres that point in the same direction. Hence, our use of the lyrics from The National in our title. Non-US investors should change their approach to currency hedging—we explore what this means for different types of investors.

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