This article is based on John Hathaway’s latest quarterly market letter. Mr. Hathaways is Portfolio Manager and Senior Managing Director at Tocqueville.
What the recent strength in the dollar index means:
The DXY index is not the dollar; it is a measure of the dollar’s relative strength. The principal components of the DXY index are the Euro (57.6 percent) and the Japanese Yen (13.6 percent). The balance (28.8 percent) consists of the Canadian dollar, British pound, Swedish krona, and Swiss franc. Therefore, the DXY index says absolutely nothing about the inherent virtues of the US currency. Instead, it reflects capital flight from yen- and euro-denominated assets from regions where the respective central banks have hatched well documented schemes to devalue those currencies as the antidote to economic weakness. There are many reasons why the dollar may remain strong against the core components of the DXY. However, whatever virtues others may see in the DXY’s ascendant pattern, we see the potential for monetary chaos.
The DXY is mute on the matter of the rapidly waning usage of the US currency to settle international trade. Deals to bypass the greenback seem to proliferate daily. The dollar has become an impediment to trade for even our closest and most important trading partners. Canada has just announced a series of deals to trade directly in renminbi, following similar actions by several Latin American countries. The Wall Street Journal (11/14/14) reports that Russia will ‘receive renminbi as payment for a significant flow of oil’ to China. Vladimir Putin commented, ‘we’re moving away from the diktat of the market that denominates all commercial oil flows in US dollars.’ As mentioned in our third-quarter investor letter, first-half trade cleared in renminbi totaled $18.3 billion, double the previous year. The institutional plumbing to circumvent the dollar is being put into place. Examples include the launch of the Shanghai Gold Exchange in September of this year, as well as the formation of the BRICs bank (in the second quarter), on the model of the World Bank, to facilitate non-dollar transactions.
In addition, Russia has announced that it is developing its own version of SWIFT, a network that enables financial institutions to communicate electronically in a secure fashion, which it expects to launch in 2015. The clear intent is to bypass Western financial institutions and conventions.
In our opinion, a world in which the dollar becomes increasingly marginalized as a reserve currency will look substantially different. As noted by Andrew Smithers in the Financial Times (11/12/14), the US is a massive hedge fund, ‘long equities and short debt,’ with an international net debtor position equivalent to 31 percent of GDP. As long as dollar reserves have utility, dollar-denominated assets can thrive. Utility is in large part a matter of perception and confidence, in our view, and the fundamentals underlying the notion of a strong dollar are sliding in the wrong direction. At the moment the long dollar trade seems extremely crowded, with CFTC speculative long exposure near record highs…
This post was published at GoldSilverWorlds on November 26, 2014.