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The Dollar's Sweet Spot



VIDEO TRANSCRIPT


Kamala Harris says that America, not China, will win the competition in the 21st century


Vladimir Putin says that a shift toward “a multipolar world order” had already begun and that it is “irreversible.”


It is clear that the power struggle between the unipolar and the multipolar world orders is set to intensify regardless who wins the US election.


There is no denying that Russia is winning the war in Ukraine but is the BRICS any closer to mounting a serious challenge to the US economic hegemony?


What are the most decisive factors in the race to the top?


How will the US dollar do in 2025?


……..


Is it a coincidence that the 2024 BRICS summit in Russia was held in the same week as the IMF - World Bank annual meetings in Washington?


Coincidence or not, the BRICS could not have made any clearer their unhappiness with the current international financial architecture.


The final communique of the summit calls for a reform of the system and a more "inclusive and just" system


As ambitious as this may sound, the communique was light on concrete steps


Indeed, the much talked about independent cross-border settlement and depositary infrastructure is still only at the stage of discussion and feasibility study.


Notwithstanding the symbolic unveiling of a BRICS banknote at the summit featuring the flags of Brazil, Russia, India, China, and South Africa, the communique was silent about a BRICS currency, suggesting a lack of consensus about its practicality or even desirability.


If we learned anything at all in 2024 is that it is too early to write off the unipolar order centered around the US and the dominance of the US dollar.


The biggest macro story this year has been the resilience of the US economy that is growing twice as fast as was expected at the end of last year.


Against this backdrop, the US dollar that the BRICS is so eager to dethrone is having another good year (Chart 1)


Among the BRICS currencies, the only currency that has done better than the USD this year is the South African rand (Chart 1)


The Brazilian real has lost 15% against the greenback and the Russian ruble 7%.  (Chart 1)


The RMB is only slightly weaker than the dollar, but this is likely only because of suspected currency interventions by Beijing (Chart 1)


It is understandable that the BRICS countries that account for 50% of the world’s population want to be unshackled from the tyranny of the dollar.


But talk is cheap.


What will it take to actually challenge the king dollar?


…..


Since the collapse of the Bretton Woods system and the start of the era of floating exchange rates in 1973, the dollar has completed 2 full cycles. (Chart 2)


The first cycle began with the adoption of a mix of easy fiscal policy but tight monetary policy under Ronald Reagan that sent the dollar soaring. The cycle peaked with the signing of the famous Plaza Accord. The dollar fell steadily in the subsequent 5 years and did not find a bottom until 10 years later. (Chart 2)


The second dollar cycle began in 1995, the year that Yahoo was incorporated, Amazon opened its online store and eBay held their first online auction. The cycle peaked with the bursting of the dot com bubble and the September 11 attack on the twin towers. Like in the first cycle, once the cycle turned, it was all the way downhill. It took 10 years before the USD finally troughed.  (Chart 2)


The dollar started its third cycle in 2014, the year that US oil production increased by the most in 100 years and the US embarked on a path towards energy independence. Unlike the two previous cycles, the USD’s ascent has not followed a straight line. This could be why 10 years into the up cycle, the dollar has not so far shown any sign of peaking (Chart 2)


Why is the dollar doing so well? How vulnerable will it be in 2025?


…,..


To answer these questions, we need a framework for identifying the key drivers of exchange rates in the new global paradigm.


But first we need a measure of currency strength


Because my interest in this video is the big market cycles that take years to play out, my preferred measure of currency strength is the real trade weighted exchange rate.


This measure also has the advantage of making cross-country comparisons easier.


For my analysis, I am going to use the monthly series published by the Bank for International Settlement.


On this chart, I have ranked 24 major currencies according to the z-scores of their real traded weighted exchange rates calculated using a 20-year window. (Chart 3)


This approach is necessitated by the fact that not all currencies among these 24 currencies are freely floating. (Chart 3)


In my methodology, a strong currency is one that is trading near the top of its trading range of the past 20 years while a weak one is trading near the bottom of its trading range. (Chart 3)


Based on this framework, the strongest currency in the world at the moment is the Singapore dollar. (Chart 3)


The USD dollar is in second place, and the Swiss franc in third place. (Chart 3)


At the bottom, we have the Norwegian koruna, the Japanese yen, and the Chilean peso. (Chart 3)


In the middle of the pack, we have the RMB, the Australian dollar, the Mexican peso, the Indonesian rupia and the euro (Chart 3)


Among the BRICS currencies, the Indian rupiah is the strongest while the Brazilian real is the weakest (Chart 3)


Now that we have established the relative strengths of different currencies, we can ask ourselves what makes some currencies stronger than others.

 

….


I have spent the better part of the last 30 years analyzing and forecasting currency returns.


If I’ve learned anything at all is that the drivers of exchange rates do not remain the same over time.


Innovation has always been an important determinant of the competitive position of any economy.


But as the power struggle between the unipolar and the multipolar world orders intensifies, the ability to innovate has become a matter of life and death as technology leaders guard their know-hows more jealously


The third dollar cycle is mostly about technology


I don’t know about you, but to me it is quite obvious that the USD’s strength of the past few years owes much to the fact that American companies account for 8 out of the 10 most valuable technology companies in the world today


So which countries are the most innovative in the world right now?


There are many different ways to measure innovativeness, but I like the Global Innovation Index created by the World Intellectual Property Organization that uses 80 different variables to measure the education, infrastructure and knowledge creation of different economies


In the 2024 Global Innovation ranking, Switzerland is in first place, followed by Sweden, the US and Singapore. (Chart 4)


Among the BRICS countries, China is the highest ranked, ahead of Japan and France while South Africa is the lowest ranked. (Chart 4)


What’s more, there is a 28% correlation between the ranking of our 24 currencies and the Global Innovation ranking. (Chart 5)


Countries with the strongest currencies right now like Switzerland, the US, and Singapore also happen to be the most innovative. (Chart 5)


This is also true among BRICS countries. (Chart 5)


China and India which have the strong currencies are also ranked higher in innovativeness than South Africa, Russia and Brazil (Chart 5)


How easy will it be for the BRICS countries to close the innovation gap with Switzerland, the US, and Singapore?


It won’t be easy because innovation is not about doing one thing well but doing many things or even all things well.


And the leaders are not sitting on their hands.


Moreover, they already enjoy the hub effect that will be difficult for other countries to dislodge.


But China is making a big push and so is India.


These countries definitely have the economies of scale.


But Swizterland, Singapore and Sweden show that small is beautiful.


…..

 

Innovation is important but it is not everything.


As population ages around the world, access to a growing labor force has never been more important for the global economic race.


On this chart, I have ranked our 24 major economies by their population growth over the past 2 years.  (Chart 6)


Singapore once again ranks at the top. (Chart 6)


In second place we have Saudi Arabia. (Chart 6)


Australia and Canada are tied for third place. (Chart 6)


Israel comes next. (Chart 6)


At the bottom of the ranking, we have Japan and Russia.  (Chart 6)


China and Korea also saw their population shrink over the past 2 years. (Chart 6)


You may be wondering whether our currency ranking is correlated with our population growth ranking.


The answer is very much yes.


The correlation is 39%, even higher than the correlation with the innovation ranking.


Singapore is high in both the currency and the population growth rankings


In contrast, Japan is very low in both rankings


The US is an outlier, with very low population growth over the past 2 years.


However, I suspect this is due to a measurement problem.


The Census Bureau is likely massively undercounting population increase due to illegal immigration.


Indeed, as I argued in another video, the 10 million illegals who crossed into the US over the past 4 years have probably helped extend the economic expansion by easing the tight labor market.  


Ironically, illegals are helping to prop up the USD right now


My predictions 

Innovation and population growth are the key drivers of economic success and currency returns in the brave new world 


By the way, the correlation between my currency ranking and the average of the innovation and population growth rankings is over 50%


Over the past few months, I have been making the case for a Trump victory in November


Whereas the market has decided to view a second Trump term through the lens of inflation, I prefer to see it through the lens of innovation. 


Trump has promised to deregulate which should boost innovation. 


The fact that Elon Musk will have a big role in his administration makes me think that innovation will be the biggest winner under Trump 2.0


By the way, innovation that raises labor productivity will be ultimately disinflationary 


Trump will crack down on illegal immigration but with more than 10 million people having entered the country, there will be enough reserve for the labor supply for the next 4 weeks


Furthermore, Trump wants to increase skilled immigration. 


In my view, if Trump does get a second chance, the dollar will be difficult to beat in 2025. 


Canada and Australia have higher population growth than the US but they fare poorly in innovation 


Japan is trying to up its innovation game but its population is falling 


Europe is falling in the innovation league table and has low population growth


India and Brazil are too low down in the technology food chain to threaten the US


Russia also has a falling population


This leaves only China as a viable challenger to the US


But Chinese population is shrinking and China quest to move up in the innovation game is being hampered by US sanctions. 


I also like the Singapore dollar and the Swiss franc. They are expensive but they might get more expensive. Owning them along side the dollar also provide a nice hedge in the event the world suddenly discovers it owns too many dollars

 

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1 Comment


Michelle.W
Oct 26, 2024

This is a sound argument. However, I'm concerned that too many are focused on the end result of no currency being ready to replace the dollar. Few are discussing the BRICS role as a disruptor at a time the U.S. debt level and deficit spending trajectory are both fragile. How much of a punch or puncture could the debt balloon take? Gold may continue to show us.

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