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Treasuries: America's Largest Export 💵
Since 1450 there have been six major global reserve currency regimes, each averaging 95 years: Portugal (1450-1530), Spain (1530-1640), Netherlands (1640-1720), France (1720-1815), Great Britain (1815-1920), and the United States (1921-present)1. The U.S. dollar's reign began in the aftermath of WWI and strengthened following WWII through the creation of the Bretton Woods system, whereby foreign currencies were fixed within a range to the dollar, and the dollar was subsequently pegged to gold. However, by 1960, the deteriorating U.S. balance of payments and declining share of global output meant decreased demand for dollars; meanwhile, growth in U.S. military spending and foreign aid increased the supply of foreign dollars. The result was a dollar glut in excess of U.S. gold holdings. Increased redemption rates ultimately forced President Nixon to suspend the convertibility of dollars for gold in 1971, establishing the floating rate system still in place today.
Throughout the Bretton Woods era, the dollar was "as good as gold," cementing its dominance in global trade. However, following President Nixon's break of the dollar-gold peg, the U.S. needed a solution to maintain foreign demand for dollars. Shortly after, in 1973, the U.S. inked a strategic agreement with Saudi Arabia, the world's largest oil producer, which agreed to price its oil exclusively in dollars in exchange for U.S. military protection2. By 1975, all OPEC nations had opted in and the petrodollar system was born. The dollar was now "as good as gold for oil." The U.S. benefitted from increased demand for U.S. Treasuries and the ability to purchase oil in a currency it prints, both of which it has defended with the full force of its military. In Former Federal Reserve Chair Alan Greenspan's book, the Age of Turbulence: Adventures in a New World, he writes "I'm saddened that it is politically inconvenient to acknowledge what everyone knows: the Iraq war is largely about oil"3. As a result of the petrodollar system, the U.S. dollar has dominated global trade. From 1999 to 2019, 96% of trade in the Americas was invoiced in dollars, and in the Asia-Pacific and rest of world (ex-Europe) regions, U.S. dollar share was 74% and 79%, respectively4.
In a 2005 speech, Former Federal Reserve Chair Ben Bernanke outlined why U.S. current account deficits are largely influenced by external factors rather than internal, a theory now known as the global savings glut hypothesis5. He described how developing countries, particularly East Asian nations following their regional financial crisis of 1998, accrued high levels of savings as a buffer against capital outflows. Most accumulated these in dollar-based foreign exchange (FX) reserves to prevent their currencies from appreciating, thus promoting export-led growth and transitioning from borrower to lender. Meanwhile, at the turn of the century, technology-driven productivity, geopolitical safety, and favorable jurisdiction dramatically increased capital inflows to the U.S., drove asset prices higher, and strengthened the dollar. As a result, rising wealth-to-income ratios increased consumer demand, while a strong dollar favored imports over exports.
This reinforcing feedback loop has lowered interest rates as surplus nations hoarded U.S. dollars and purchased U.S. Treasuries, enabling the U.S. to run ever-increasing deficits with little consequence. In fact, from 2002 to 2012, the total value of foreign Treasury purchases was nearly $3.9 trillion, greater than the combined value of major export categories: foods, feeds, and beverages, automotive, and consumer goods over the same period6. Unsurprisingly, China accounted for nearly 30% of foreign purchases, dramatically expanding its U.S. dollar-based savings consistent with Bernanke's savings glut hypothesis7.
De-Dollarization: Slowly, then all at once 🕚
In 1971 and the decades since, the U.S. has been a victim of the Triffin dilemma. Economist Robert Triffin observed that a nation whose currency is serving as the global reserve cannot correct a balance of payments deficit without starving the world of foreign exchange reserves8. In other words, short-term domestic objectives are at odds with long-term international goals.
In recent years, several nations outside of the G7, particularly China and Russia, have realized that U.S. debts won't be paid back in real terms and have taken steps toward de-dollarization. China has long had goals to dethrone the dollar, and as the world's second-largest exporter and top importer of crude oil, it is in pole position to do so9. In 2014, consistent with a peak in its U.S. Treasury holdings, China announced the One Belt, One Road (OBOR) initiative, President Xi's vision for a modern economic revival of the ancient Silk Road. Through OBOR, China seeks to grow the renminbi's usage in global trade, particularly in strategic developing nations currently underexposed to regional and international financial markets. In 2018, China launched oil futures contracts denominated in yuan but convertible for gold on the Shanghai exchange to appeal to oil producers looking to move off the U.S. dollar10. It has also sought more significant influence in global payments infrastructure, including a joint venture with the SWIFT system (a Belgian-based global messaging network for cross-border transactions). Lastly, China is the world's first central bank to propose a CBDC (central bank digital currency), which some speculate might be partially backed by gold11.
China may entertain a gold link to overcome many of the (self-inflicted) impediments to the renminbi's international growth it has faced to date. These include the ban on free trading of the renminbi in foreign exchange markets, a closed capital account, and relatively low international confidence in Chinese institutions and domestic law4. The Chinese central bank has been the second-largest net purchaser of gold since 2002, closely behind Russia, and collectively central banks worldwide have been large gold accumulators since 2009, having previously been net sellers since 198912. A reversal of this decade-long behavior is a sign of growing distrust in the existing fiat system and a preference for gold in an alternative monetary order.
Like China, Russia's de-dollarization efforts have come in the three areas of U.S. dollar dominance: FX reserves, trade, and payment infrastructure. Russia's pivot away from dollars accelerated in 2014 following U.S. sanctions imposed in response to Russia's (initial) invasion of Ukraine. From 2013 to 2020, Russia cut its share of U.S. dollar FX reserves in half and eliminated all U.S. dollar assets from its sovereign wealth fund11. As of 2020, 50% of Russian trade was still in U.S. dollars, but dollar exports to the rest of the BRICS nations (Brazil, India, China, South Africa) were just 10%, down from 95% in 201211. Concurrently, Russia has developed its own national electronic payment system, Mir, and a SWIFT alternative (System for Transfer of Financial Messages – SPFS)11. Bottom line - Putin has been accelerating his transition away from dollars for nearly a decade, a rather important signpost in the context of today's conflict.
Macro strategist Luke Gromen believes Bretton Woods II, a 50-year monetary regime, ended on February 26th, 2022 – the day the U.S. sanctioned Russia's access to its U.S. dollar reserves13. The U.S. effectively announced to the world, "your dollars are only good if we say so," a clear signal to any nation questioning their current or future relationship with the U.S. or its allies to decrease the U.S. dollar share of their FX reserves. Since the start of the conflict, de-dollarization markers have accelerated significantly.
- Russia has demanded that "non-friendly" nations make payments for natural gas in rubles14.
- Saudi Arabia is considering selling oil to China for yuan, which would negate the nearly 50-year-old agreement between the U.S. and Saudi Arabia previously described, threatening the heart of the petrodollar system15.
- Relatedly, the Biden administration has attempted to court Saudi Arabia and the United Arab Emirates to boost oil production amidst rising prices, but both declined to meet16. The administration even considered sourcing from Maduro's corrupt Venezuelan regime before tapping the Strategic Petroleum Reserve (SPR), which now stands at a nearly 20-year low17.
- Russia abandoned the 20% Value-Added-Tax (VAT) on gold purchases for its citizens, incentivizing gold over foreign currencies18.
- Russia announced it would buy gold from domestic banks at a fixed price of 5,000 rubles per gram, a program they have subsequently halted but contributed to the ruble recovering all of its losses versus the dollar since the invasion19.
Another major contributor to ruble strength has admittedly been strict capital controls, therefore recovering on low volume. Nevertheless, the relative stabilization of the ruble signifies that Russia's supply of natural gas, oil, and gold will serve them well in this new monetary regime. If Putin's actions haven't already made it clear, hear it from the horse's mouth:
"Let me reiterate, the global economy and global trade as a whole have suffered a major blow, as did trust in the US dollar as the main reserve currency. The illegitimate freezing of some of the currency reserves of the Bank of Russia marks the end of the reliability of so-called first-class assets. In fact, the US and the EU have defaulted on their obligations to Russia. Now everybody knows that financial reserves can simply be stolen. And many countries in the immediate future may begin – I am sure this is what will happen – to convert their paper and digital assets into real reserves of raw materials, land, food, gold, and other real assets, which will only result in more shortages in these markets."20 - Vladimir Putin, 3/16/22
As of 2021, the U.S. dollar still comprised 59% of global FX currency reserves, down from 71% at the turn of the century21. We expect this share to decline at an accelerated rate following recent events.
Bretton Woods III: The Good, the Bad, the Ugly 💣
Professor Perry Mehrling, creator of the "Money View" school of economic thought, teaches four prices of money: 1) par = the price of money today, or the assumption that deposits and currency are always exchangeable one for one, 2) interest = the price of money tomorrow; or the amount willing to pay today for future money, 3) exchange rate = the price of money in foreign exchange, 4) price level = the price of money in terms of commodities, or the purchasing power of money22. Prices 1-3 exist in the nominal realm, whereas the price level is the "real" price of money. Zoltan Pozsar, interest rate strategist at Credit Suisse and arguably one of the world's leading experts on the inner workings of the financial "plumbing" ecosystem, highlights how central banks can and have printed to solve crises in the nominal realm. The 1998 Asian financial crisis was a crisis of exchange rates, 2008 a crisis of par, and March 2020 a crisis of interest rates23. Today, Poszar argues we are entering a price level crisis catalyzed by the Russian conflict's exacerbation of commodity shortages. This is central bank kryptonite, as they cannot print oil, natural gas, base metals, grains, rare earths, or other core inputs across the commodity complex.
In stark contrast to the globalization we've become accustomed to, the world looks to be shaping into an "us" vs. "them" edifice and a new monetary order alongside it. The reversal of globalization is the transition from a singular global supply chain made for efficiency to duplicate supply chains built for resiliency - "just-in-time" manufacturing to "just-in-case." This will require reshoring the U.S. industrial base previously exported to China, along with our inflation (and pollution). Such a transition wouldn't be possible under U.S. dollar hegemony, in most part due to the Triffin dilemma, which has led Luke Gromen to believe the U.S. Department of Defense knew precisely what they were signaling when sanctioning Russia's FX reserves13. In times of increasing geopolitical tension, the state, not the central bank, drives monetary policy, while the Federal Reserve will attempt to clean up the mess (inflation).
Rebuilding America's industrial base will require significant investment from both government and corporations. Unfortunately, this comes when no natural buyers of U.S. Treasuries exist to finance such spending. The logical consequence is a continued rise in U.S. interest rates, which the U.S. government cannot afford, thus necessitating further central bank action to avoid nominal defaults on our obligations. The Federal Reserve may ultimately be forced to resume quantitative easing while inflation is already untethered. If that doesn't scream hard assets, we're unsure what does. The U.S. dollar is the core of the financial system, and the U.S. Treasury market is the core of the core, the collateral on which our debt-driven global monetary system is built, and precisely why a precipitous drop in demand for Treasuries is so concerning.
While the re-industrialization of America is likely to come at increased short-term costs, it should eventually lead to long-term stability, particularly in areas such as sustainable energy independence, manufacturing self-sufficiency, and national security. Many sectors will be the beneficiaries of targeted spending, including infrastructure, network communications, manufacturing, and materials. We believe the adoption of innovative technologies will be a necessity, rather than a choice, in order to meet the productivity requirements of such a transition amidst a background of rising prices and labor shortages. The intersection of disruptive technologies, including 5G for enterprise, robotic process automation, and 3D printing will drive significant production efficiencies. In fact, a recent survey of manufacturers found that on average the respondents estimated cost savings of 38% attributable to 5G alone24.
If U.S. dollar hegemony's expiration date is approaching, what system will replace it? It's not yet clear, but we hypothesize that some combination of gold, silver, and commodities will play a more pivotal role. Perhaps not too dissimilar to John Maynard Keynes' Bancorp proposal to create an international unit of account based upon a basket of gold and commodities, which ultimately lost out to the gold standard in Bretton Woods I25. Keynes knew the world requires a neutral reserve asset, meaning one that is not someone else's liability. Historically, gold has played this role due to its indestructibility, physical scarcity, and divisibility, which fulfill money's three fundamental properties: a medium of exchange, a unit of account, and a store of value. However, gold's key shortcoming in the modern monetary system is its relative lack of portability. The Bretton Woods gold standard tried to circumvent this by using the U.S. dollar as a proxy, while the gold itself primarily stayed put.
We believe it is not outside the realm of possibility that Bitcoin will play a role in the new monetary order. A previous blog, Bitcoin: Ignorance is not Bliss, describes how Bitcoin improves upon many of gold's monetary properties, specifically solving the portability problem. An infinitely scarce, digital, and instantly transportable neutral reserve would serve as the ultimate form of system collateral. In addition, its database (the blockchain) is publicly available and auditable to ensure there is no misreporting of balances. Did we mention it's government tamperproof? In economics, game theory is the study of how and why actors make decisions. Well, let's suppose our actors are G7 nation-states deciding whether or not to purchase Bitcoin or recognize it as a currency. Game theory tells us the rational outcome for both nations is to buy Bitcoin or risk the other gaining a relative advantage.
Bitcoin may be coming to a country near you.
Gold, silver, commodities, and Bitcoin. Given the prevailing environment, one would expect these "hard monies" to be in high demand. Strangely, the gold price hasn't budged much in the face of record money creation and inflation. This is likely due to the overwhelming size of the paper gold market relative to physical, which are claims upon physical gold in the form of futures, options, ETFs, and other derivative contracts. Estimates put the paper gold market some 20x-30x larger than the physical market26. The financial productization of gold has exponentially increased its "availability" and suppressed spot prices. The rehypothecation of gold is akin to a fractional reserve banking system, and just as a run on the banks causes systemic collapse, a run on the physical market would cause failures in paper gold.
Explosive moves in monetary metals, gold and silver, would destroy the last vestiges of the fiat system. Interestingly, as part of the Bank for International Settlements' (BIS) post-2008 banking reforms, the Basel III accord reclassifies physical gold as a Tier 1 asset with a risk weighting of zero; meanwhile, unallocated (paper) gold remains a Tier 3 asset. Additionally, Basel III stipulates banks the new Net Stable Funding Ratio (NSFR) for gold is 85%, meaning banks must back unallocated gold with 85% cash, up from 0% pre-Basel III27. The BIS is effectively telling banks to get their house in order when it comes to unallocated gold and identifying the paper market as a significant systemic risk. Following a 1-year deferral due to Covid, Basel III reforms will take effect on January 1st, 2023, and follow a 5-year transition schedule28. We expect these changes to dramatically increase the cost of unallocated gold, further straining an already tight physical market.
The thesis we've laid out has significant implications for traditional asset allocation frameworks. The typical 60/40 portfolio is based on a 40-year bull market in bonds, whereby Treasuries were the safe-haven asset inversely correlated to equity returns. Yet, in this new monetary regime bonds look to be in a secular bear market, which has already unveiled itself in 2022 as the U.S. 30-year Treasury index has fallen nearly 20%, almost three times the 7.5% year-to-date decline in the S&P 50029.
We'll leave readers with the following graphic. What happens if $245 trillion in fiat denominated assets chase $15 trillion of hard monies? Stay tuned.
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2 Salameh, Mamdouh. Has the Petrodollar had its day? June 2015
3 Greenspan, Alan. The Age of Turbulence: Adventures in a New World. September 2007.
4 Bertault, Beschwitz and Curcuru. The International Role of the U.S. Dolllar. Board of Governors of the Federal Reserve System. October 2021.
5 Bernanke, Ben. The Global Saving Glut and the U.S. Current Account Deficit. March 2005.
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8 Triffin, Robert. Gold and the Dollar Crisis: Yesterday and Tomorrow. International Finance Section, Department of Economics at Princeton University. December 1978.
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10 Evans, Damon. China Sees New World Order with Oil Benchmark Backed by Gold. Nikkei Asia. September 2017.
11 Congressional Research Service. De-Dollarization Efforts in Russia and China. July 2021.
12 World Gold Council. World Official Gold Holdings. April 2022.
13 Gromen, Luke. The Grant Williams Podcast: Luke Gromen. March 2022.
14 Cohen, Patricia. Putin says 'unfriendly countries' must buy Russian Oil and Gas in Rubles. New York Times. March 2022.
15 Said, Summer. Saudi Arabia Considers Accepting Yuan Instead of Dollars for Chinese Oil Sales. Wall Street Journal. March 2022.
16 Nissenbaum, Kalin and Cloud. Saudi, Emirati Leaders Decline Calls with Biden during Ukraine Crisis. Wall Street Journal. March 2022.
17 U.S. Energy Information Administration. U.S. Ending Stocks of Crude Oil in SPR.
18 Bloomberg News. Russians Buy up Gold to Salvage Savings After Ruble Collapse. March 2022.
19 Reuters News. Russia Central Bank says it will Stop Buying Gold at Fixed Price. April 2022.
20 Permanent Mission of the Russian Federation to the European. Russian President Vladimir Putin on situation around Ukraine, international relations and sanctions. March 2022.
21 IMF Data. World Currency Composition of Official Foreign Exchange Reserves.
22 Mehrling, Perry. The Four Prices of Money. Colombia University Lectures.
23 Pozsar, Zoltan. Money, Commodities, and Bretton Woods III. Credit Suisse Research. March 2022.
24 The Manufacturing Institute. How 5G is Transforming the Manufacturing Landscape. March 2021.
25 Alden, Lyn. The Fraying of the Current U.S. Global Currency Reserve System. December 2020
26 Nemethy and Scalabrini. An Upcoming Paper Gold Crisis? 2020.
27 Bank of International Settlements. Basel Committee of Banking Supervision. Basel III: The Net Stable Funding Ratio. October 2014.
28 Financial Stability Board. Basel III Implementation. October 2021.
29 Refinitiv Data.