The Dollar Is Still King

It appears that the recent stock rally was more driven by expectations of a hopeful recovery than being based on any real recovery. The inevitable can be expected of any such surreal rally and the stock markets, after a brief positive spell, have been heading down again.

These spells of brief rallies followed by a downturn have their own impact on the value of the dollar. Each stock market rally appears to result in a withdrawal from dollar holding and investment into riskier securities. This results in a dip in the value of the dollar. But, as soon as investors realize that the there was no real recovery in the economy, they liquidate securities and head back into the safe haven of the dollar. This leads to the dollar firming up.

Investors, who bought stocks close to the bottom and sold at higher prices, had the chance to book neat profits. Then we saw them move to the safety of the dollar. This presents a chance to the small investor to interpret trends and move between different asset classes to maximize their profits. While, there can be a long term view, the current opportunity lies in tracking the capital flow between the dollar and risky securities.

This also leads to another reality of global financial markets. Beyond the humdrum of replacing the US dollar as a reserve currency by an alternative, the dollar continues to be the king as it appears to be the choice for safety. There appear to be many factors that make it difficult for the dollar to be replaced by an alternative in a hurry.

The most stable replacement for the dollar as a reserve currency is gold or the gold standard. But the gold standard has severe limitations that hamper the independence of monetary policy. The gold standard restricts the amount of currency that can be in circulation by linking it to the gold held by the central bank. This linkage was broken first by Britain in 1914 in order to fund its operations during World War I. The UK did return to the gold standard in 1925. However, with the US becoming the dominant power towards the Second World War, the dollar became the predominant currency, with other major currencies being pegged to the dollar. The dollar itself was pegged at $35 to an ounce of gold. In 1971, in order to fund the Vietnam War, Nixon removed the peg with gold, which enabled the US to induce a massive expansion of dollars in circulation for funding the war. Thus, reverting to a gold standard seems improbable as it curtails the independence of monetary policy.

A proposed alternative is the IMF’s SDRs. Though China and Russia have backed the SDR proposal vehemently, the SDR seems to be an unsuitable candidate as it is not an independent currency. Moreover, the IMF is not a bank, which can borrow and lend in private markets and is only for governments. Thus it cannot pass for a currency and cannot be traded. These factors make it difficult for the SDR, in its current form, to be instituted as a substitute to the US dollar as a reserve currency.

The dollar has been able to serve as a reserve currency due to the strength of the US economy and the nation’s political dominance in the world. Thus, the future of the dollar as a reserve currency is largely dependant upon how the economy shapes up and how the balance of economic and political power take shape. With China determined to play a more dominant economic and political role and its economy supporting such a move, in the long run the dollar may eventually lose some of its sheen to be substituted to some extent by other currencies like the Euro amongst others. However, there seems to be no ready replacement available at present. While this denotes a long term trend, in the short run, the dollar is likely to continue with its status of predominance. Profiteering lies in following short term money flows between asset classes of equities and currencies and assessing trends by tracking the upward and downward movements in the dollar.