Episode 5: The rise (and potential fall) of the USD as global reserve currency.
25 May 2022
Today we continue our carriage drive down the country road of economic history.
The story is picked up in the early eighties with Paul Volcker busy “killing” inflation with almost unprecedented levels of short term interest rates at 21%
Interest rates play a major role in affecting currency price sentiment, and as a consequence the dollar began to strengthen as investors took advantage of the yield offered in the USA.
The knock on effect of the strong USD was that nations whose currencies were weakened by the interest rate differential began to export into the US and the US trade deficit began to widen.
Once again export nations began to accumulate large USD surpluses (reserves) that needed to be warehoused somewhere, and once again the US bond market was the obvious choice.
The formula is fairly easy to understand. You have a weak currency, so you stimulate the manufacturing sector, then you sell your product (cars, durable goods, Electronics) to the nation with the strong currency, thereby accumulating that nation's currency and investing in the high yielding assets of that nation. Wash rinse and repeat. The strong currency nation is happy because they can buy cheap products from abroad, and the weak currency nation is happy because they can stimulate economic growth and employment through manufacturing. It sounds like a perfect formula for Nirvana.
Except for one little problem ….. this little mechanism ensures that jobs are lost in the strong currency regime. The other issue is that this causes structural imbalances in these nations' current accounts. The export nations accumulate surpluses, and the import nation large deficits, financed by the recycling of these flows into the bond market of the host nations' reserve currency status.
Ordinarily, large trade deficits would lead to weaker currencies, but because the USD was/is the global reserve currency the USD did not weaken because its deficits could be easily financed.
In this case, because the USD is the reserve currency (world trading currency), that nation is allowed to borrow more on the international stage than they ordinarily would be able to….remember that export nations need to park their reserves somewhere, and so US borrowings continued to rise.
This all became unsustainable by 1985. The USD was too strong, and any further strength would entrench the issues stated above, creating larger economic issues for all the nations affected.
And so the G5 decided to get together at an event known as the Plaza accord (named so because the meeting took place at the Plaza Hotel in New York)
The solution agreed upon was to actively intervene in the currency markets in order to weaken the USD. You can read about it here.
The impact of this accord was far reaching and there is an argument that says much of Japan's woes of the last 30 years is partly due to what occurred during this period. Cause and effect, decisions and consequence.
Incidentally, this was about the time a began my career in the markets, and I was about to experience quite a steep learning curve over the next 5 years.
What happened next also arguably has its birth in the aftermath of the Plaza Accord.
For a while, the USA experienced moderate growth and lower inflation, and consequently, the equity market in the US rose substantially over the 5 year period starting in 1982.
Global trade imbalances however were still an issue, and every time the Trade balance declined in the US the markets were spooked and were fearful that governments would again intervene to weaken the USD.
The pressure was building.
I recall that as a junior trader the most anticipated number that we were trained to watch at that time was the US trade balance released monthly.
Importantly, it was also during this period that computing power increased to such an extent that for the first time, computers could be programmed to execute orders based on some elementary algorithm.
During 1987 the Dow Jones industrial index had returned a whopping 69% return for the year, until October of that year.
On Wednesday 14 October 1987 the US trade figures were released, and they were bad, causing the USD to weaken, and bond yields to rise.
Equity prices declined by a few percentage points for a few days.
But in the background, more selling pressure was building and computers were programmed to execute sell orders at regular intervals.
And then on Monday 19 October 1987 all hell broke loose. Forever remembered as Black Monday.
The US stock market collapsed by about 20%, and other markets globally fell by as much at 45%, In a single day.
This collapse revived fears of a 1929 type great depression, and the US FED was quick to respond by slashing interest rates and providing liquidity to the markets through open market operations.
They were successful ….and markets stabilized relatively quickly.
The age of the economic crisis was born. But so was the response playbook. Markets collapse, and Central Banks respond by adding liquidity. The response gave rise to the so called “Central Bank Put”. In layman’s terms – the lender of last resort will step in and save the day.
This playbook response would allow punters to increase risk and leverage with the confidence that if things turned sour, central banks would save the day.
It would be repeated many times over in the decades to come.
But that’s it for this episode. But I leave you with the following to consider….
With the advent of FIAT money after Nixon moved off the gold standard, economic crisis were becoming frequent occurrences. However, every crisis led to more reliance on the USD as reserve currency, and also reliance on Central Banks, especially the FED, to solve the crisis.