The dollar in trouble. Large depreciation ahead.

The US has become the most indebted major economy to the rest of the world - by far. Policies are making it worse, not better. Big, and wide-spread, market correction ahead during 2026-27.

Greetings from my favourite café here in Clerkenwell,

Today’s note is about the dollar. I’ll argue that it is in serious trouble in terms of value, but that its role as the world’s preferred currency for invoicing, settlement, and transactions is less at risk. Its reserve currency status is unlikely to be challenged by the predicted depreciation, but it would be if the US government were to move down a path of misguided policies directly impacting its creditors − a non-trivial risk. Markets will be late to see this coming, but governments in creditor countries, including in Europe, should take action now to limit the downside risk to the serious imbalances in the US.

It’s pretty clear that the dollar doesn’t like President Trump’s foreign economic policies, so to speak: it took a hit following the so-called Liberalisation Day on April 2 last year, which was the first concrete illustration of Trump’s determination to replace decades of cooperative US international economic policies with a new and coercive approach. By the end of the year, it had lost 10% of its value in trade-weighted terms and – importantly – it began to trade significantly weaker against the euro than interest rate differentials would have suggested.

This new trend was then interrupted when Trump began to add military aggression to his playbook earlier this year (Venezuela, the threat against Greenland, and now Iran): the dollar started to strengthen because in such circumstances its safe-haven status tends to overpower investors’ economic concerns. Still, the trade-weighted dollar has only regained about one-third of last year’s loss.

Granted, the dollar may appreciate some more in coming weeks as Trump’s war-of-choice continues, but he is clearly looking for a way out of the quagmire he has caused, not least as both equity and fixed-income markets are now beginning to get beaten up. When Trump pulls out, the safe-haven support for the dollar will begin to evaporate. But while Trump will be forced to scale back his military aggression, I see no realistic prospect of him changing his coercive foreign economic policies into something more cooperative.

Therefore, one should expect a large dollar depreciation during the next year or two - maybe by 25-30%, driven by economic fundamentals, including key US macro imbalances, which Trump’s economic policies will further exacerbate.

Ironically, this past Thursday it was announced that President Trump will have his signature added to US dollar bills later this year, the first time a sitting president has done so. Officially it’s to celebrate the US’ 250-year anniversary, but it is just the latest in a long list of American landmarks to which Trump has added his name. The previous one, the Kennedy Center, has since closed “for renovation”, following an exodus of contributing artists and audience. I predict the addition of his signature to the dollar bills may mark a similar exodus of investors and users of the dollar!

Now to the economic arguments why the dollar is in deep trouble in terms of value.

Today’s note is inspired by an excellent piece this past week by the FT’s Katie Martin, https://www.ft.com/content/ccdbf058-c395-416a-9e69-212cd52463d3?shareType=nongift in which she discussed the impact on the dollar of the war in the Middle East – as well as by the large number of old friends and clients of my former employers who, triggered by Martin’s piece, reached out to discuss the issue.

In the FT, Katie Martin reflects on two starkly opposing views by markets analysts on the fallout for the dollar − and markets more broadly − of the war in the Middle East.

At one extreme is David Zervos at Jefferies. Zervos seems to enjoy his self-appointed role as “Trump-Versteher” and defender of his policies (you really don’t find those types here in Europe, so that makes for interesting reading). He sees no fundamental trouble ahead for global markets, calling the moves and volatility since the US-Israeli attack on Iran “excursion-related fearmongering” and “largely irrelevant”, so he feels “quite optimistic that this too will pass.”

At the other extreme is George Saravelos at Deutsche Bank. According to Martin, Saravelos argues that markets underestimate “the strategic importance of the Middle East to the dollar’s role as the world’s reserve currency” − the petrodollar − and argues that “if faultlines are further exposed, there could be significant downstream effects on the dollar’s use in global trade and savings.”

I disagree pretty profoundly with Zervos. Trump has disrupted the world order in ways not seen in decades, and his approach to foreign economic policies and diplomacy is not only cause for markets to sell the dollar, as we saw last year, but for its allies to feel a lot more than “quite cranky”, as suggested by Zervos. “Betrayal” or “outrage” would be closer to what Europe should – and does – feel towards Trump’s America, which in turn should – and will - inform future policies towards the US. Put a pin in that.

So, I’m closer to sharing Saravelos’ concerns, but my worries about the impact on the dollar are somewhat different.

The Arab oil producers no longer recycle their revenue back to the US via US banks as they did in the petro-dollar days of the 1970s and 1980s. Now, they mostly invest it directly at home and globally, to a significant extent bypassing US banks and the dollar. It’s therefore difficult to see the present war in the Middle East as the “perfect storm” for the dollar, as suggested by Saravelos.

But that won’t prevent the dollar from suffering large depreciation because of economic fundamentals. Here is why.

While the US has outperformed Europe and much of the rest of the world during these past 10-15 years, it has come with a stunning build-up in debt to the rest of the world. Most importantly, this has been driven by the US federal budget deficit, which has averaged a massive 6.5% of GDP per year during this period. The deficit is still at that level, and with no realistic prospect of future adjustments to bring it down to sustainable levels.

Consider this for illustration: if the US wanted to cut the deficit in half (let’s be generous and think of that as “sustainable”, even though it would still be greater than the deficits in most other OECD countries) exclusively by cutting spending, it would – on a rough calculation − have to eliminate 2/3-3/4 of all discretionary spending. If it wanted to do it exclusively by raising taxes, total tax revenue would have to increase by about 1/3. I see no scenario in which either of these, or a combination of them, would be politically palatable in the US in the foreseeable future.

Therefore, holders of US Treasuries ought to be concerned. A whopping 18% of all federal tax revenue needs to be allocated to the payment of interest on the public debt – that’s almost four times higher than in France (which somehow has become a worry in markets)! Without policy action, the US interest-to-revenue ratio will increase to an estimated 23-25% during the next ten years, according to the PIIE and Apollo – and that’s before including the effects of the roughly 20bp higher 10-year yields which we saw just this past week. If the cost of the war (around $2bn a day) plus further increases in funding costs due to inflation concerns were to push that ratio towards 25% at a faster pace, when would the political fabric react? – and how?

These excessive fiscal deficits have contributed to the stronger US GDP growth; but they have also fuelled a huge deterioration in the US’ Net International Investment Position, the NIIP. (That’s a country’s net debtor or creditor position vis-à-vis the rest of the world.) Twenty years ago, the US’ NIIP was broadly in balance. Ten years later it had increased to a net debt of $7 trillion (40% of GDP). It’s now -$27.6 trillion, or -85% of US GDP. Among OECD countries, only Spain, Portugal, Greece and Ireland have had such large negative NIIPs at any time during the past 50 years, and you know how that ended.

The US’ huge negative NIIP position is, of course, nothing more than one side of the “global imbalances” debate. The other side consists of the creditor countries, including China, Japan, and Germany: but none individually has a positive NIIP of more than about $4 trillion. In other words, today’s global imbalances are predominantly a US deficit problem, rather than a surplus problem among one, or a few, other countries.

Nevertheless, in the ideal world, the countries with the greatest imbalances would agree a coordinated policy approach to reduce these imbalances. Like the Plaza Accord in the mid-1980s, this would have to include at its core an agreement for the US to reduce its deficit, while the major surplus countries would expand their fiscal stance to lower their savings surpluses (as, indeed Germany is now doing for other reasons).

But policy coordination is not Trump’s thing, as so vividly illustrated. Still, with France chairing the G7 this year, the issue of global imbalances will be discussed when the G7 meet in mid-June and – at least intellectually – we are in good hands. Professor, and incoming head of BIS monetary and economics research, Helene Rey, is leading the G7’s academic group on global imbalances, and I understand that some truly good papers are soon to be published.

When this hits the headlines during the next few weeks, and if you are interested, do reach out to my colleague at Independent Economics, John Llewellyn. Few people have greater understanding of global imbalances, and how they typically play out, than John. His experience goes all the way back to the Plaza Accord, when he, with OECD colleagues, was directly involved in the policy discussions and calculations that underpinned the Accord.

Meanwhile, here’s why it’ll all end in a massive dollar depreciation.

While the US went from a broadly balanced economy vis-à-vis the rest of the world twenty years ago to now being the industrialized world’s most heavily indebted to foreigners, the trade-weighted dollar appreciated by about 30% away from what the OECD’s PPP-based calculations imply as its long-run fair value. (EUR/USD moved from 1.60 to 1.16.) In other words, on average during those years, capital inflows into the US – or at least into dollar denominated assets – outweighed the US current account deficit. They financed partly the budget deficit (foreigners now own about 30% of all federal debt), but also – and increasingly so – private investments, particularly in the tech industry. It seems very unlikely that those flows will continue at the same pace in this new and more fragmented world.

I’ll leave it to you to speculate about possible correlation and/or causality between the vast deterioration in the US’ NIIP and the huge dollar appreciation, but one thing is clear: the NIIP cannot continue to deteriorate indefinitely. And given that the only policy adjustment which would stop it from doing so, namely a large reduction of the budget deficit, is low probability, the probability of a corrective market reaction must be equivalently high. And when the FX goes, it usually moves not only substantially, but it overshoots its fair value, whatever exactly that may be. I’m not a great believer in PPP as an exact measure of fair value, but if it’s even broadly right, a 25-30% dollar depreciation seems well within the range one should expect.

In normal times, such a dollar depreciation − back to around fair value − might not cause broader trouble: but things are not “normal”. The federal budget deficit is huge, debt service (including to the 30% foreign holders) absorbs an eyewatering share of fiscal resources, and we have a president − surrounded mostly by advisors picked more for their loyalty to the president than for their known expertise – with, shall we say, unorthodox views on economic policy matters.

Therefore, there must be a high probability of US yields moving still higher both because of the expected effect on inflation, but also because of the share of the debt held by foreigners. And the even greater share now being bought by foreigners might require still greater compensation as the dollar weakens. You see my drift… it’s unlikely to be a pretty scenario.

As John Llewellyn has pointed out to me (and to clients of Independent Economics), before we get to this, or as it begins to unfold, one must consider the risk of administrative intervention by the US government to keep creditors invested, i.e. financial repression. This could happen via changes to regulation or taxation to incentivise – or even to oblige − US financial institutions, e.g. pension funds, to buy and hold more Treasuries. Or, in this world of “America first”, one must consider the risk that maturing Treasuries held by foreign creditors suffer a forced roll-over, e.g. into very long dated securities with a below-market interest rate, an idea floated by Stephen Miran, Trump’s Chair of the Council of Economic Advisors and now also an FOMC member.

I have no idea what will trigger this: a problematic policy announcement? A weak Treasury auction? An event in the corporate world? A pause in the credit boom for tech? But the direction of travel towards a lower dollar, higher yields, and potential problems for the Treasury seems overwhelmingly likely, even if the timing and sequence remain unknown.

If past reactions to major macro imbalances are anything to go by, markets move late, but then violently. As the great Rudiger Dornbusch observed: “the crisis takes much longer coming than you expect, and then happens faster than you would have thought possible”.

This means that policymakers elsewhere, including in Europe, ought to put in place, already now, policies and regulation to encourage their financial agents to reduce their exposure to dollar denominated assets, and particularly to US Treasuries – not because of the risk of mark-to-market losses, but because of the global ramifications of mayhem in US financial markets and hence the systemic risk the US imbalances and possible policy choices implies for other countries, including Europe.

Eurozone financial institutions and other residents in the eurozone hold gross foreign assets of EUR 34 trillion (227% of GDP), of which EUR 14.6 trillion is in portfolio investment, including an estimated EUR 2 trillion directly in US Treasuries – or 13% of eurozone GDP. At present, eurozone financial institutions add EUR 50-100bn per year to their US Treasury holdings, driven by their risk-free status and higher yields. I’m worried about the stock of holdings – and I am appalled that Europeans continue to bring their savings to the US to help finance their budget deficit.

The most obvious policy changes for Europe would be to adjust financial regulation to treat eurozone sovereigns as being of higher creditworthiness than any other sovereign, including the US. Think about it: no highly developed society can justifiably consider any other government as creditworthy as its own government. Equally important, European tax laws should be adjusted to encourage the eurozone’s annual EUR 300bn savings surplus to be invested in productive investments in Europe, rather than abroad.

After all, at a time when Europe’s prime ally has turned into an adversary, not only should European savers not continue to help finance him and his economy [sic – I’m stunned how it has become common for Trump to talk in the first person singular pronoun about the US economy, diplomacy and military forces]. Rather, protection against the financial – and ultimately systemic − risks should be enhanced by encouraging private capital to be invested productively in Europe.

And with that, I’m fully caffeinated for the day and ready for a walk along the Thames.

Best

Erik