The Demise of the US$?

By: David Chapman | Thu, May 22, 2014
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Charts created using Omega TradeStation 2000i. Chart data supplied by Dial Data

In one of the biggest deals of the century, China and Russia have signed a $400 billion natural gas (NG) deal that will deliver roughly 38 billion cubic meters of NG to China over the next 30 years. The deal also includes a $10 billion aviation deal and a $2.6 billion power agreement with plans to build auto plants, housing and rail connectivity. The deal gives China's National Petroleum Corp. a 19% stake in Russia's oil company Rosneft. The deal gives both China and Russia a stake in each other's future. It helps Russia untether its ties with Europe and ensures co-operation between the two powers going forward. It will also help deter US attempts to isolate Russia through sanctions.

The agreement between China and Russia is just a start. A $42 billion 4,000 Km pipeline is to be built into China. Russia holds the world's largest reserves of NG. The deals are to be settled in "mutual payments in national currencies". What that means is that the deal is to be transacted in Yuan and Rubles and not US$ as would currently be the case. It is the "de-dollarization" of trade.

So is this another "nail" in the coffin of the US$? Well no, not exactly. But it is another step forward. The reality is that despite everything the US$ remains the world's reserve currency. And it should remain that way for the foreseeable future despite calls, led primarily by China, for a new world reserve currency. While global use of the Chinese Yuan has grown over the past few years, the Yuan is still only roughly 10% of global trade flows. The Euro is now below the Yuan. There is a case for the Yuan to join the Euro and the Japanese Yen as a part of central bank reserves.

The US$ for the foreseeable future is most likely going to remain the currency of choice for many. The Euro has had its issues primarily because the Eurozone is at best a collection of states who have failed to consolidate either their debt or their central banks even though there is an ECB. The Euro parliament has become a mish-mash and with pending elections it seems the dominate members of the parliament will come from anti-Euro parties. That is not a positive thing going forward even though the Euro members want to maintain the Euro as their currency but they don't like answering to a central authority. That leaves the member states of the Euro zone not a lot different from US states. The reality is, however, that the quality of debt varies from country to country with Germany remaining the best and economic basket cases like Greece and Spain amongst others bringing up the rear as their debt is not much better than junk.

There are few other challengers to US$ supremacy. Certainly not the British Pound Sterling or the Japanese Yen. Although both are significant, their economies are just not big enough to come anywhere near the US. But China is not ready either and certainly not Russia. Both countries have had trouble in selling their bonds. That puts a cap on capital flows and while trade flows may be good it is capital flows that count and here the US remains dominate. The question here is would an institution rather park its excess cash in US Treasuries or Chinese and Russian securities. Odds are high it would be the former.

A few countries such as Panama, Ecuador and El Salvador have adopted the US$ as their currency. Others such as Saudi Arabia, and surprisingly Venezuela have tied their currency to the US$. China is not tied but it is certainly traded within a band with the US$. Numerous countries issue debt in US$ thereby taking on the currency risk themselves. All of this creates demand for US$ and allows the US to run their trade deficits without causing a currency crisis.

But there is danger going forward. The de-dollarization taking place between China and Russia is also spreading elsewhere as China in particular cuts more deals with countries to conduct trade in national currencies rather than the US$. The huge government debt of the Euro countries , Japan and the US is also a major problem going forward. Right now it would appear that the Euro zone is the most vulnerable to debt default even though the Debt/GDP for Japan is much larger. If there is to be another major debt crisis, and I continue to believe that it is a matter of when not if, the debt defaults might start in the Euro countries before moving to Japan and then finally the US.

Country debt defaults are not uncommon. Prior to 1800, even Great Britain and the US defaulted. For Britain, the last default was in 1472. As to the US, it defaulted on debt following the American Revolution in 1790. Arguably, the US also defaulted in 1933 when it reneged on gold-based obligations and raised the price of gold from $20.61 to $35. It was a in reality a debt default by revaluing its currency down sharply in relation to the price of gold. A similar argument could be made when former President Nixon took the world off the gold standard in August 1971. Over the next decade the US$ repeatedly fell in value against other major currencies.

Russia on the other hand has defaulted five times since 1800. The last default was in 1998. China has defaulted twice since 1800. Both times were in the last 100 years. Some have cited Russia's huge external debt primarily owned by European and US banks as another reason as to why sanctions against Russia are very difficult. The Russian debt default in 1998 caused a panic but it was contained. Today a Russian debt default would make the Lehman Brothers default of 2008 look like a "walk in the park".

The US$ Index is trading down at levels that were seen in the late 1970's. The US$ Index appears on the monthly chart to be tracing out a either a five point reversal pattern or a descending triangle. It is difficult to say which at this stage. The US$ Index could fall to the bottom of the channel currently near 74. If it is a five point reversal pattern forming then US$ Index could then rally and rebound up through the top of the channel near 83. Above that, a major rally could get underway projecting up to objectives near 102.

On the other hand, if this is a descending triangle forming then a break down under 74 could see the US$ Index fall to potential objectives down near 55. There are US$ bulls and US$ bears each touting their own interpretation of the status of the US$ Index.

One thing that appears certain is the de-dollarization should continue to grow given the current direction and the Yuan should continue to grow in importance and one day might achieve reserve currency status. But an immediate collapse in the US$? Most likely not going to happen. Even a fall to 74 and the bottom of the channel would be positive for gold that generally moves opposite to the US$. If one looks back at what happened to the US$ Index from 1987 to 1995 they might note a seven-point reversal pattern. A fall this time to 74 or even down to the long term major down trend line currently near 70 could complete a possible comparable seven point reversal pattern that started with the US$ Index low in 2008.

If there is a concern about the US$ it is its loss of purchasing over the past century. I have shown this chart in the past but it is worth showing again just to bring home the reality of how much the US$ has really fallen in terms of purchasing power. For over 100 years from the beginning of the US the US$ held its purchasing power. What that means what one could buy for $1 in 1800 you could still buy roughly the same basket of goods for a $1 in 1900. No longer. The US$ has lost 97% of its purchasing power primarily since the creation of the Federal Reserve back in 1913. That is not a pretty picture. The real demise of the US$ has taken place with its loss of purchasing power.

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David Chapman

Author: David Chapman

David Chapman

David Chapman

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