The Dollar Endgame?

2021-03-24 | Sam Shames

A year ago, the world found itself gripped by a novel coronavirus that changed the path of history and what we used to consider normal.

The consequences of immediate and long-lasting shutdowns that normally would have crippled world economies were circumvented by monetary powers by sacrificing the dollar so that asset prices would remain elevated.

In only a year, central banks around the world have added close to $20 trillion in new liquidity into the system. This is without precedent in history, and we have seen asset prices in almost everything respond to all the newly created dollars and fiat.

The price of everything from stocks, to housing, to commodities (like lumber) have risen quickly over the past year as the newly created dollars flood the zone with liquidity.

So, the logic is that all the newly printed dollars will have an inflationary effect on the short and long term, and the logic makes sense, and we are seeing the early stages of it now.

However, what if the longer-term picture is different from what most expect?

I took a poll in the Simpler Trading Gold Room asking the room what they thought the longer-term direction of the dollar would be.

Overwhelmingly, the response from the room was the expectation for inflation. Which, again, is a very logical choice as unprecedented money printing should result in higher inflation.

But what if that inflation is only transient?

What if the inflation that central banks are desperate to create is only a sugar high based on stimulus and the larger deflationary forces of technological innovation and large debt burdens worldwide still win?

My bias is that the endgame for the dollar will not happen how most expect (through an inflationary cycle that takes the value of the buck much lower), but rather a deflationary wave that forces the powers that be to undertake something similar to the Plaza Accord.

In the short term, I acknowledge the inflationary forces at work. They are undeniable, and we see evidence of it in almost every asset class.

However, here is the argument for deflation to prevail over the intermediate and longer-term.

All currencies are traded as “pairs,” meaning that in order to buy one currency another must be sold against it.

The classic pair is the EUR/USD where if a trader wanted to buy the Euro, they would sell Dollars against it. If enough traders are demanding Euros, we will see upward pressure on the Euro and downward pressure on the dollar.

Forex trading is essentially a seesaw where one currency gets pushed down and, by that effect, the other currency gets pushed up.

It’s very easy to make the argument for inflation of the dollar based on optics alone. They’re printing dollars non-stop, therefore the value must drop. It’s a logical conclusion.

The bear case for the dollar therefore is easy to make. However, understanding the forex seesaw, what would be the bull case for the Euro to go significantly higher?

In order for the inflation narrative to have legs long-term, there must be an equally forceful and valid argument for the Euro to go much higher, and I have not found one.

If anything, Europe has done as many monetary shenanigans as the United States during this time period with a backdrop of a weaker economy than here in the States.

So, point one would be that we have to have a bullish argument for the Euro for the inflation narrative to work and, at least for myself, I have yet to find a valid argument for the Euro to move higher over time.

The second point is a mechanical one relating to how debt is created.

Every dollar that exists was at some point borrowed into existence. At the fundamental level when new dollars or credit (interchangeable for this argument) are created, they are created by borrowing from a central bank or commercial bank.

Someone needs dollars, they borrow it from a bank, the bank borrowed it from the Fed. The person gets dollars and a promise to pay it back with interest at a later date.

There’s an entire paper that could be written about where the money for the interest payments comes from if all money is borrowed into existence, but we will skip that for now.

So, if we understand that every dollar is borrowed into existence, then the opposite is also true, when debt is repaid those dollars get destroyed or erased from existence.

Therefore, the creation of dollar-denominated debt around the world has a short-term inflationary effect as more liquidity is introduced into the system, but also has the opposite deflationary effect if/when those debts begin to be paid off.

The unique problem that the dollar has that makes it different from other historical case studies of inflation, such as Weimar Germany or Zimbabwe, is that the dollar is the world reserve currency. Because of this, loans across the world, regardless of country, are oftentimes denominated in dollars. For example, a country in Africa may need to fund a project and receive a loan from an institution denominated not in the African country’s currency, but rather in U.S. dollars.

Every time this happens, any time a new debt is issued that is denominated in dollars around the world, it creates an implied short position on the dollar.

They borrow today with the promise to repay tomorrow. They receive dollars today, but at some point in the future they must buy more dollars to repay the loan principal as well as the interest. It’s the same as short selling a stock, sell it today with the intention of buying it back later.

All debt must eventually be paid back with dollars, which means at some point they have to go to the market to buy these dollars to repay the debt. All new debt creation implies this.

Essentially, the biggest short position in the world without comparison isn’t Gamestop stock, it’s the U.S. dollar.

It’s a version of catch-22. The more debt, the more inflation in the short term. But also the more debt gets repaid, the more deflationary effect on the system.

The third point is technological innovation. In order for real inflation to take hold over a longer timeframe, it also has to overcome the deflationary effects of technological innovation.

As technology improves with time, it increases the productivity and output of economies. This has also had the effect of creating lower prices than before as things can be made more efficiently.

I will keep this point simple as it’s not the center point of the argument, but it is an additional drag on the inflationary narrative that many believe.

So, how does it all end?

In my opinion, we are on a path to the dollar losing its world reserve currency status. The result will be that the world will create and adopt an alternative to the dollar, most likely based on a basket of currencies rather than just the buck.

Something similar to the SDR system of today. –

This seems to be an intentional force by the monetary powers that be, and my bias is that they will eventually achieve their goal.

However, unlike most, I don’t believe that it will be a weakening dollar that forces this new paradigm, but rather a dollar that is too strong in the future and forces the “powers that be” to embark on something similar to the Plaza Accord where countries actively and overtly try to weaken the dollar.

We will not see any evidence of the need to do this until we see a debt repayment cycle reverse after the stimulus sugar rush invariable wears off.

In space terminology, the Fed may be able to run the printer at light speed, but the deflationary forces discussed act as a “black hole” whose gravitational pull eventually still wins out.

Remember that in an expansionary environment, like we are in currently, the deflationary effects we have discussed here remain hidden. They only reveal themselves when the speculative fever breaks and the creation of new loans slows, and debt repayment returns.

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