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US dollar dichotomy may affect the world in the coming times

Financial markets seem overconfident in assuming that the central banks will certainly intervene when required, an assumption that may or may not turn to reality every time

Currencies are a part of the monetary system and governance of monetary system is left with the central banks of individual countries. The US Federal Reserve governs the monetary system of United States. The Federal Reserve system was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of financial panics led to the desire for central control of the monetary system.

The US dollar has been the world’s principal reserve currency since the end of World War II and is the most widely used currency for international trade. Until the recent past, US dollars was the most commonly held reserve currency and the most widely used currency for international trade and financial transactions around the world when other currencies such as the euro, British pound and Chinese yuan to some extent gained some form of traction and a share of the foreign currency reserves / foreign trade.

Let us glance through the developments in the financial world where US dollar is being extensively used and its impact. Firstly, In response to the Covid-19 pandemic in 2020, the Federal Reserve opted for massive quantitative easing to facilitate recovery of their economy, raising value of their total assets at a rapid pace from $4.15 trillion in February 2020 to $8.965 trillion by April 2022, an increase of 2.16 times in a span of two years with the aim to boost the country’s growth to overcome the dent caused by the pandemic. The financial markets propelled through the roof, rising at an even higher pace globally, also giving rise to inflation. Whilst the Federal Reserve has initiated the process of offloading assets from its balance sheet (a process termed as quantitative tightening) and reduced asset size on its balance sheet to $7.439 trillion as of April 3, 2024, they have miserably failed in assuming inflation as transitory and the world continues to face after effects of rising inflation. Inflation is like a gazelle that has outpaced the lion far ahead.

Secondly, The Federal Reserve opted to raise interest rates at the fastest pace in history, raising 525 basis points interest rate within a span of 17 months from March 2022 to July 2023 to slow down the pace of growth and rising inflation that was caused due to introduction of excess liquidity introduced by the regulator in financial markets. Unfortunately, the Federal Reserve did not succeed in slowing down their economy and US economy achieved a real GDP growth rate of 1.9 per cent in 2022 and 2.5 per cent in 2023 while inflation also continued to rise.

Now comes the tricky part. In pursuit of their obligations, the US government continued to raise debt at an unprecedented pace, reaching a level of $34.6 trillion as of February 2024, and its last $1 trillion debt was raised in 100 days, the fastest rise in debt ever. With this pace of debt or borrowing by the US government, a figure of $40 trillion by the end of the year 2025 may be a reality. Out of the existing debt of $34.6 trillion, $8.9 trillion worth of government debt will mature over the next 12 to 15 months. The US government budget deficit in 2024 is estimated at $1.4 trillion, according to the Congressional Budget Office, taking the total amount of debt to $10.3 trillion, that will have to be financed/refinanced/rolled over. Stakes are high considering that almost one third of the debt will have to be refinanced/financed and the United States may have to maintain interest rates at current levels to lure the lenders be it local or foreign. In the process, interest rates may continue to stay higher for longer.

It is noteworthy to mention that the staggering debt also carries a hefty interest bill of approximately $1.1 trillion estimated for the financial year 2024. Some fundamental questions that may arise. Can any government globally ever repay this staggering level of debt? Is this sort of annual interest bill sustainable? Is this financial prudence at a sovereign level? We will hardly find an answer to these questions.

While the Federal Reserve has suspended any further hike in interest rate from August 2023 onwards, indications were given directly or indirectly in various forums in the past few months that there would be rate cuts in future and that they may achieve soft landing (an action whereby the Federal Reserve may just raise the interest rate enough to slow the economy without causing recession). Month on month, Federal Reserve has been changing its narrative on rate cuts and its action of keeping a check on inflation and achieving two per cent inflation target is just a dream that may seldom come true. The Federal Reserve was aiming for soft landing, assuming that US economy would slow down and this target is also a miss. On the other hand, the inflation curve has already picked up and Federal Reserve may not be able to catch this air balloon that has started flying up.

To add to the woes, the Federal Reserve published their financial statement for their financial year that ended on December 31, 2023, and their income statement showed a loss of $114.3 billion. Moreover, the Federal Reserve has an unrealised loss of $948 billion on their holdings, as published in the same financial statement. Imagine, the central bank of a country, whose currency is being considered as reserve currency worldwide, having a loss in their own financial statements in a financial year. This is a signal that all may not be well.

The Federal Reserve has kept the world completely bemused with speeches and their actions going completely contrary to their targets of controlling inflation and slowing down the economy. The whole world is kept guessing and changing goal post in terms of one, two, three or four rate cuts between 2024 and 2025, with the recent assumption of one or two rate cuts by the end of 2024.

Financial markets always consider probabilities of known unknown and price these developments in day-to-day market movements. Financial markets seem overconfident in assuming that the central banks will certainly intervene when required, an assumption that may or may not turn to reality every time.

These developments are just a tip of the iceberg that we as readers seldom pay attention to. However, the central banks worldwide are much ahead of what a common man could think of and their actions of building gold reserves over the last two years as compared to buying US Treasuries give a clear signal that they prefer precious metals in their custody over US Treasuries that may be subjected to some form of restriction or block in future. Central banks are reaffirming their old belief on gold that has historically played a crucial role in bolstering the value of a country’s currency and viewed as a dependable asset in times of economic uncertainty.

For reference, gold demand by central banks in the calendar year 2022 was 1,081.9 tonnes and demand in the calendar year 2023 was 1,037.4 tonnes. This demand/buying is over and above existing gold reserves that central banks worldwide hold, that is approximately 11,700 tonnes fetching a price tag of $900 billion at current market prices. These reserves are at central bank level and gold held by individuals or institutions is excluded from this figure. In fact, some of the large economies have opted to devalue their currency and there is a buying frenzy for gold across retail traders in some of the large economies, to safeguard themselves from any financial hazard.

Moreover, countries worldwide are embracing dedollarisation and accelerating the pace of bilateral trade between them and engaging into trade transactions directly, bypassing the US dollar, which is a clear sign that dedollarisation, as a process, is gaining immense momentum and this momentum is not fading away.

Financial markets worldwide are at all-time highs or a few yards from all time highs and the commodities have also jumped into the race, with sudden spike in prices. Welcome to a fragmented financial world that is no longer in sync while the crowning glory of the US dollar may be gradually fading. The financial world is in a conundrum where bond price movements signal rate hike, gold price movements signal rate cut, equity markets assume soft landing, oil price movements and copper price movements says recession is left behind and housing prices are signalling rate hike.

Politics is the mother of economics. Ultimately, the Federal Reserve will always prefer to place their nation’s interest first compared to global interest and hence, they will prefer to navigate this challenging path anticipating outcome that suits their interest at best. In such a scenario, countries globally may be left on their own to manage their financial affairs while bracing for impact caused due to actions initiated by the Federal Reserve.

All in all, the financial world is going to see a bumpy ride in the coming times and the inflation flight has just taken off and this flight may not land back very soon, challenging the Federal Reserve to counter this trend while leaving behind their dream of soft landing. The world needs to brace for this impact, be it inflation or shakeups that may be caused in the financial markets due to decisions initiated by the Federal Reserve. These developments in the financial world and the ongoing geopolitical developments are a sign of some turbulence that is brewing that the world needs to be prepared for.

The writer is founder and CEO of ZTI Global.