FUNDAMENTAL ANALYSIS
against US profligacy. So long as the world had faith in the Dollar, and decided against converting Dollars to gold, everything would be fine.
However, the fiscal strains for the US began to show in the 1960s, and in August 1971 the US ended the convertibility of Dollars into gold, and the world order shiſted from an effective Gold Standard to a US Dollar Standard.
For decades, the Dollar standard has worked incredibly well. Credit creation, untethered from gold and controlled by commercial and central banks, has led to strong global growth and rising asset prices. Te dark side of the Dollar Standard is that it has also
shiſts away from the Dollar Standard.
Recently, we have the following dynamics to consider;
1. Trump slapping tariffs on selected items with more to come
2. China hinting that they would hold fewer reserves in US Dollars
FX
tightening that will see the Fed’s balance sheet reduced by $450 billion in 2018 and likely more in 2019
Tese dynamics, together with Trump’s more isolationist agenda, are threatening the Dollar standard. So the big picture questions are 1) will the Dollar standard remain in the years ahead and 2) if it changes, how and what will the new system look like and 3) what will happen to the global economy and markets during any transition?
Chart 1 – Weekly chart of US 10 year bond yield
The extraordinarily orderly decline in US yields over the last 30 years has reached an important tipping point
led to an unparalleled growth in debt in virtually every country and every sector. Te economic outcome is that rather than the economic cycle being mostly about inventory cycles, it is now much more sensitive to boom and bust cycles in the financial markets.
But so long as everyone played to the rules of the Dollar Standard, things would generally be ok. What we don’t know is what would be the impact on the global economy and global financial markets if the global system
3. Other central banks admitting that they are already holding more reserves in Yuan, and that they expect the amount to be higher in the future
4. US Treasury secretary publicly saying a weak Dollar is good because it will help the US trade position
5. Te passing of US tax legislation that is likely to lead to a much larger budget deficit
6. Te beginning of quantitative
These are such big issues that we won’t be able to answer them in
one
article. What we can see is that if global in v e st o r s begin to lose
confidence in the Dollar at a time when US inflation is rising, bond yields are rising, the Dollar is weakening, the budget deficit is set to increase dramatically and the US central bank is draining Dollars from the system, there is a case to be made that the future may not be quite as bright as many pundits are currently claiming.
But these dynamics change relatively slowly, and financial markets are currently in no mood to think negative thoughts.
FX TRADER MAGAZINE April - June 2018 43
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