The US government has executed three significant policy mistakes since late 2017. In December that year, Congress cut taxes just as the US economy reached full employment. Then, in April 2018, the Federal Reserve turned hawkish as it misjudged the temporary sugar high from the tax cut for higher trend growth. A month afterwards, President Donald Trump abandoned America’s abiding commitment to free trade by levying an extensive assortment of duties on Chinese imports. Despite these policy blunders, the currency went up. If any other country had played the same game, it would have been punished in currency markets and devalued by credit rating agencies.
Why can the US act in this manner with plain impunity in the markets? The answer rests on the dollar’s stature as the world’s pre-eminent global reserve currency. Such a position is like insurance – it ensures access to funds in rough moments. The US can access finance even when it causes crises as in 2008-09. It likewise controls the extent of its own insurance payout by setting the number of Treasuries it issues.
Whilst financial controls also assist in the currency’s exceptional prominence with US government bonds are given a 0 percent risk assessment under Basel III because they are considered risk free. Whilst rating agencies do their part by allowing higher valuations to the US bonds than to bonds in less beholden, quicker growth countries without reserve currency status. The piece de la resistance: central banks earmark over 60 percent of the world’s $11tn of forex reserves solely to the dollar. However, these immense advantages do not ensure that the dollar, a floating currency since October 1976, will maintain its power. The policy mistakes since late 2017 now weigh on the dollar, which is down this year despite European and Chinese economic vulnerability.
If the US slowdown becomes more intense, there may be more near-term support for the Swiss franc, Japanese yen, gold and even crypto currencies. At root, the dollar’s reserve currency status depends on American willingness and ability to lead.As America shrinks from global leadership, it is prudent that all investors begin to take currency diversification far more seriously than they have done in recent years.