Of all the financial trends that have surprised economists and analysts over the past few months, it has been the rise in the value of the U.S. dollar that has caught us off-guard, yours truly included. After its central bank printed four trillion in new dollars, after the government posted record annual deficits that pushed the national debt past $18.0 trillion, after other world central banks started reducing their exposure to the greenback as a reserve currency, the consensus was the U.S. dollar would fall in value.
But as is often the case, the trend went against what the majority had predicted. Since June of 2014, the U.S. dollar is up 20% against a basket of the world’s most popular currencies. There are really three reasons why this has happened: 1) the Federal Reserve has stopped printing paper money and is promising to raise interest rates, while other central banks (except for the U.K.) are printing money or lowering rates; 2) the euro has all but collapsed, so investors are turning to the greenback; and 3) oil prices have collapsed making the currencies of major oil-producing countries like Russia weak.
The trend in the strong U.S. dollar might be short-lived, though.
Renminbi Becoming a Global Currency?
Other currencies, like the Chinese renminbi, often referred to as the yuan, are gaining attention and countries are choosing them over the U.S. dollar. In November of 2014, the renminbi became one of the top five currencies used in the global trade. Prior to this, it was ranked number seven, and in 2013, it was positioned 13th.
According to the Society for Worldwide Interbank Financial Telecommunication, which connects financial institutions and lets them exchange financial information, when it comes to global trade, the renminbi has shown triple-digit growth for the past two years. In 2014 alone, the total value of payments in renminbi increased by 102%. (Source: SWIFT, January 28, 2015.)
The U.S. dollar remains the main currency in the overall global trade, but the growth in the use of the renminbi as a trade currency shouldn’t go unnoticed. It is gaining strength very quickly.
Central Banks Losing Appetite for U.S. Dollar
Aside from the rise in the use of the yuan in world trade, central banks are still pulling away from the use of the greenback as a reserve currency.
After the Bretton Woods Agreement, the U.S. dollar became the reserve currency of choice among world central banks. This trend is changing.
The chart below shows the composition of the U.S. dollar compared to overall FX (foreign exchange) reserves between the fourth quarter of 2011 and the third quarter of 2014.
The chart shows the trend clearly: central banks are reducing the amount of reserves they keep in U.S. dollars. Go back even further (to the year 2000), and you will find the U.S. dollar making up less and less of the overall FX reserves at the central banks.
When Will the U.S. Dollar Lose Its Reserve Status?
I don’t expect the dollar to collapse all of a sudden. But with the continued growth of China as a world economic power, rising U.S. debt levels, and an overpriced U.S. stock market, the fundamentals do not suggest a prolonged rally in the U.S. dollar. In fact, they suggest the opposite.
Yes, the yuan will gain strength as China takes over as the world’s largest economy. But let’s not forget that in the past, when the U.S. dollar has weakened, gold has rallied. And if the Chinese peg or back the renminbi to/with gold, as I eventually suspect in the years ahead, the U.S. dollar could come under major downward pressure.