Altus Insight April, 2018

~~The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor

Date: April 30, 2018
FR: Forrest Jinks
RE: Currency in Reserve

Seven years ago this month, the topic of the Altus Insight addressed the possibility of the United States losing it status of the holder of the world’s reserve currency, and the possible effects of that upon our economy, and inflation rates in particular. So far, not much has happened in that regard. Or maybe said better, what has occurred over those seven years has not yet brought us to the tipping point where one could truly say the world economy has changed in that regard. But, just because business has gone on as usual doesn’t mean that changes haven’t, and aren’t, occurring. We will revisit that topic this month and discuss where we might be in that process.

There are many advantages to having the world’s reserve currency. For consumers it provides purchasing power across the globe. For the government it makes it easier to run deficits since other countries need to hold dollar reserves to facilitate trade and the best way for them to hold those reserves is in US debt. Along those same lines, that increased demand for federal government debt holds down the interest rates associated with those debts. In the late sixties/early seventies the dollar ascended past the British Pound to become the acknowledged dominant reserve currency. Shortly thereafter we dealt with the inflation produced by the oil supply shock. Interest rates have been on long trend line down ever since.

 

 

Not only have lower interest rates been a tailwind of the US economy, the deficit spending, both in government spending and in trade, has occurred at a much lower cost to the economy than would have otherwise been possible without the dollar being the reserve currency.

We can use quantitative easing as an example. Huge amounts of dollars were “printed” into the economy. In a closed economy this surely would have led to inflation, which was the hope of Federal Reserve. While the inflation occurred in asset prices, it hasn’t yet occurred in the real economy. Why not? Despite the amount of money added to the economy, it didn’t stay long within the US economy. The world economy has massive amounts of USDs outside the US economy, both as government reserves and as the currency used in trade. Those USDs outside the US economy have been able to absorb the new infusion of currency, and spread the impact of the extra currency without seeing much of an impact on inflation. It is no surprise then that asset prices inflated when general economy prices did not. Foreign governments and investors may not transact in the day to day economy, but they do buy US investments. The more demand there is for those investments, the farther the price is pushed upward. In the case of debt, as prices push upwards, yields are correspondingly pushed downward. More dollars ‘printed’ meant more dollars leaving the US through the purchase of foreign goods and services, which meant more USD outside the US which then in turn could be, and often was, invested back into the US.

While USDs returned to the US as investment and pushed asset prices upward, the amount of USDs in circulation in world trade should not be understated. While considerable general trade between foreign countries occurs in USDs due to the stability of the currency, one particular commodity in international trade towers over all others in the terms of trade value. This is, of course, oil.

There is no coincidence that the USD transcended to the unchallenged reserve currency in the same time period as the US begin to provide security and arms to Saudi Arabia (the world’s largest producer of oil at the time), and Saudi Arabia in turn began to only price the lifeblood of their economy only in US dollars. Oil has been priced in dollars ever since, creating massive demand for dollar float throughout the world.

This brings us to where we are today:

1. China is heavily pushing oil trade into Yuan. First through their direct investments into capital projects in oil producing companies that, in turn, secured contracts for oil in Yuan, and now more recently through the construct of a gold futures market in Hong Kong, where countries can easily sell oil for Yuan and then immediately trade that Yuan into gold. Most of the world considers gold a stronger reserve than the Dollar. Everyone accepts gold.

2. China is the largest importer of oil in the world. Their reduction of use of the USD in their oil trade reduces the amount of dollars needed for global economy float. At the same time, the US has dramatically curtailed their net import of oil, resulting in fewer dollars leaving the US and being entered into global trade. I don’t have a way to verify this, but this reduction in oil imports could be contributing to the drop in the velocity of the USD.

3. The reduction in dollars leaving the US means foreign governments and sovereign funds no longer have a growing need for US reserves, and hence a reduced need for US debt.

4. This is happening at the same time as available US debt is ballooning. This is occurring for two reasons:

 

  • a. The Federal Reserve is now unwinding its quantitative easing. QE was the act of buying debt. This was the mechanism in which they were able to push dollars into the economy. Unwinding of QE is doing the opposite, pulling dollars out of the economy and producing more debt to be absorbed by non-Federal Reserve buyers.

     

  • b. Government debt continues to grow. The current budget further increases the need for new debt over the already high level of the past few years, despite the economy being in a growth phase and tax receipts being at a record level.

5. As the Yuan becomes more commonly used in global trade, USDs will return to the US. This may help absorb some of the available debt mentioned in paragraph 4.

6. However, private investors as the new holders of the USDs are more discerning with where they put their money than governments. Returns, and the risk associated with those returns, matter.
Based on the above reasoning, I come to the following conclusions:

 

  1. USD is likely on the path to losing its status as THE reserve currency. It will still likely be A reserve currency, but not the only one. This isn’t unprecedented. The USD and the British Pound shared the reserve status from the end of WWll until the USD became THE reserve currency as discussed above.
  2. Interest rates are likely to increase as more US debt comes in to private investors hands. This could happen regardless of where the natural rate of interest moves. Some feel the natural rate of interest is still in a structural down trend due to demographics and the burden of government debt.
  3. Depending on how/when/where all the reserves and economic float re-enter the US economy, it could cause a dramatic spike in inflation. However, to add to the thought started in conclusion #2 above, with slowing productivity due to the demographic changes and government debt, this inflation could really be stagflation.
  4. I find it highly likely the Federal Reserve will re-enter the debt markets as a buyer. Large increases in interest rates would hurt the tepid economic growth. The Fed doesn’t want that to happen, especially in this sort of scenario. Once back in the debt buying game, the Fed may never leave. The Bank of Japan hasn’t, and so far, they have been able to put off the true day of reckoning.

It is easy to blow off the conclusions as laid out because nothing like this, this impactful to our economy and our lives, has happened for a long, long time. Very few of us still in the working years of our lives have known anything but the USD as the reserve currency. But that doesn’t mean change won’t happen, it is just that recency bias is too easy of a trap to which to fall prey. When I was Indianapolis this month I met with one of the top apartment brokers in the area and mentioned our underwriting process had changed because we wanted investments to still work with interest rates at 6%. He said, and this is a guy that has been in the business for a long, long time, that interest rates will never go back to 6%. As recently as 2007, only 11 years ago, the ten-year treasury was over 5%, putting apartment money well over 6%. Only 11 years ago. 

Just because something hasn’t recently doesn’t mean it won’t happen. Just because something could happen doesn’t mean it will happen. No one can predict the economy with any degree of timing accuracy. Trends last longer than makes sense, and then correct farther than we think possible. All we can do is have our portfolio structured in such a way to deal with such uncertain certainty.

Happy Investing.


Forrest Jinks
Altus Equity Group, LP
off: 707/932-5887
fax: 707/544-2972
www.altusequity.com