Dear Investors,
(13 Updates) Wells Fargo Investment Institute – The dollar is highly unlikely to lose its global status overnight
“Recent moves to denominate some oil transactions in Chinese yuan have led to a surge in reports about “de-dollarization” and the loss of the U.S. currency’s dominant role in global finance.”
“Agreements among 🇸🇦 Saudi Arabia, 🇨🇳 China, and 🇷🇺 Russia to price some oil transactions in Chinese yuan exemplify this trend.”
“Global currency status does not disappear overnight. The reason is because the U.S. dollar remains massively dominant in the “plumbing” of the global financial system (by which we mean its role in international trade and payments, and its dominance of borrowing by international financial institutions).”
Dollar’s share of international financing
“The dollar’s share of international financing is stable at around 50% – 60% of claims and liabilities, with only the euro as a serious competitor.”
“Such dominance means powerful “network effects2” and serious barriers to entry for any contender to world currency status. And we notice that all the main alternatives to the U.S. dollar here are developed market currencies — even the Chinese yuan, most often cited as the main threat to the dollar, is nowhere.”
Financial markets are unparalleled
“U.S. financial markets are unparalleled globally in terms of depth, liquidity, and governance, which makes the dollar the most desirable medium of exchange for efficient — and, importantly, transparent — transactions.”
“The euro is the most obvious challenger in this regard, as noted, but it has the major drawback of being a supranational currency, with no single national authority underwriting its viability or ensuring its stability.”
Global trade
“The Fed report cited earlier shows the dollar’s share of export financing at virtually 100% within the Americas, and even in the Asia-Pacific region at more than 70%.”
“Most of the world’s trade is between U.S.-aligned developed markets and will continue to be denominated in dollars.”
“In this context, recent reports of yuan-denominated oil sales, while significant as evidence of growing geopolitical realignment, are little more than symbolic in terms of overall trade volumes.”
Trust in the dollar
“Trust in the dollar as a store of value is in turn backed by the rule of law and robust institutions, of which the Fed – able to respond quickly and efficiently as a “global firefighter” – is a prime example.”
“The fact that the Fed now regularly opens U.S. dollar swap lines with major developed central banks in times of financial stress should be seen as a sign of U.S. institutional strength as well as of persistent global demand for dollars.”
“This is not the case for the Chinese yuan, for example, whose international role remains, at best, nascent.”
(8 must reads) Charles Schwab – China is opening back
“China’s economic data once again exceeded expectations last week.”
“To put it in perspective, the data has been so much stronger than economist forecasts that the positive surprises are the highest since 2006, a year that marked the end of the BRIC (Brazil, Russia, India and China) era of booming growth.”
“China’s GDP growth picked up from a pace of just 0.6% in the fourth quarter to 2.2% in the first quarter. If it were reported like U.S. GDP, that is nearly 9% at an annualized rate.”
Consumer sentiment
“Consumer sentiment has improved but remains below pre-COVID levels, indicating opportunity for further thawing.”
“The next phase of recovery is likely a gradual return to underlying growth as consumers get more distance from the zero-COVID days, jobs and income prospects improve and confidence recovers.”
“We will be watching China’s national Golden Week holiday, which takes place in early May, for a potential boost in both travel and spending.”
US-china tensions
“While China’s economic growth is likely to remain strong, U.S.-China tensions are unlikely to significantly lower in the near-term. But looking out past the potential flare up in May, tensions could begin to cool.”
(12 updates) Bridgewater – Respect to the economy & markets
“Last year’s historically large and rapid tightening is starting to constrict the financial system and slow the economy.”
“The tightening cycle began roughly one year ago. It takes about that long for a tightening to have significant economic impacts, and signs are emerging that the effects are now spreading and deepening.”
“The combination of central banks raising interest rates and draining reserves with banks experiencing more constrained deposit and capital conditions and now tightening credit standards is very likely to constrain the flow of money and credit to markets and the economy, with impacts on spending and income.”
Respect to the economy & markets
“The inflation rate is too high, the rate of nominal spending is too high to bring that down, the rate of unemployment is too low to bring wages down, and despite nominal growth being too high, the real growth rate is lower than desired.”
“With respect to the markets, bond yields are too low in relation to cash and discounted inflation rates are well below current and projected inflation rates, so there is no risk premium in bonds.”
“There is a roughly normal risk premium in equities relative to bonds based on current earnings and the current bond yield.”
“But if you get a recession as needed to get the desired inflation rate, earnings would be about 20% lower, making the earnings yield too low in relation to bonds at the same time as the bond yield is too low in relation to cash.”
Path to equilibrium
“In order to have a sustainable 2% inflation rate at a 2% real growth rate, you need wage growth to fall to around 2.5%.”
“To reduce wage inflation, you need to cut nominal spending and income growth in half to 3-5% and raise the unemployment rate by 2% or more.”
“To raise the unemployment rate, you need to drive nominal GDP growth materially below wage growth, compressing profit margins enough to produce about a 20% decline in earnings.”
“Then central banks need to remain restrictive for about 18 months, until 2% wage growth is achieved.”
“Then they can restore a normal yield curve and risk premium in bonds by cutting short-term interest rates to about 1% below bond yields.”