A reserve currency is a foreign exchange instrument held in significant quantities by central banks, governments, and monetary authorities as an integral part of foreign exchange reserves. Reserve currencies are critical for international commerce and investments and are the lynchpin of the global economy.
The U.S. dollar is a fiat currency that has been the leading instrument for just over a century. A fiat currency derives its value from the full faith and credit of the government that issues the legal tender. The U.S.’s stable political and economic systems and position as the world’s wealthiest and most powerful nation established the dollar as the leading reserve currency.
A 2022 alliance between China and Russia may have planted the seeds that have led to de-dollarization and the decline of the U.S. dollar’s role in the global financial system over the coming years.
The history of reserve currencies
There have been six reserve currencies since 1450. From 1450 through 1530, Portugal dominated the currency world, handing the torch to Spain from 1530 through 1640. The Netherlands owned the world’s top currency from 1640 through 1720, when France took over the leadership role until 1815. Great Britain ruled the world financial markets until around 1920 when the United States and the dollar rose to the top spot. Ironically, each period lasted around a century, and the dollar’s term has eclipsed the one-hundred-year anniversary.
Aside from time, recent events have made the future of the dollar’s dominance dubious.
Why a handshake began the era of de-dollarization
In February 2022, China’s President Xi shook hands with Russian leader Vladimir Putin, creating a “no-limits” alliance. Less than one month later, Russian troops invaded Ukraine. U.S. and NATO sanctions on Russia have caused Russia and China to forge financial paths that circumvent the dollar and euro for cross-border transactions. Together with allies, de-dollarization has begun to take hold, with the Saudis selling oil to China in yuan and India in rupee. China and Russia have reduced dollar and U.S. government bond holdings, have increased gold holdings, and have led an effort to create a BRICS currency with some gold backing to challenge the dollar’s dominant role.
The handshake creating the China-Russia alliance began the era of de-dollarization.
Gold has been a fiat currency barometer since the turn of this century
In 1999, the United Kingdom, the hub of the international gold market and the regulator of the bullion market, sold half its national gold reserves. U.K. leadership decided that gold was no longer a financial asset but a barbarous relic of past centuries.
The gold auction caused the precious metal to fall to a $252.50 per ounce low in 1999. In 2024, the price is around ten times higher as other central banks did not follow the U.K. that foolishly put its faith in fiat currencies with only the backing of the full faith and credit in the governments issuing the legal tender. Over the past few years, central banks have more than validated gold’s role in the worldwide financing system, increasing their gold holdings, classified as foreign currency reserves.
The chart shows gold’s ascent over the past twenty-five years. As gold has been around a lot longer than all the fiat currencies, including the U.S. dollar, gold’s price rise tells us the purchasing power of fiat money has deteriorated. Based on the gold price, one U.S. dollar in 1999 is worth ten cents in 2024.
Debt, internal political divisions, and bifurcating nuclear powers have caused the dollar’s role to decline
De-dollarization is only one factor weighing on the U.S. dollar value. While the bifurcation of the world’s nuclear powers threatens to create another means of exchange that challenges the dollar, U.S. debt at over $35 trillion is bearish for the U.S. currency’s value. Even if spending and revenues balance and the deficit does not rise, the 5.375% Fed Funds Rate adds over $1.88 trillion to the debt annually. Rising debt erodes the dollar’s value and standing as the global reserve currency. Massive U.S. debt levels make the U.S. currency and government debt instruments less attractive to foreign investors.
The sixteenth U.S. President, Abraham Lincoln, stated, “A house divided against itself cannot stand.” U.S. domestic political division is another factor weighing on the U.S. currency and its world standing. The November 2024 election will be a close contest, and half the country will be more than disappointed with the results. U.S. political division has risen over the past few years and could reach a boiling point in the coming years.
The ramifications for commodity prices- DBC and GSG are diversified commodity ETF products
A weak dollar tends to be bullish for raw material prices. While the dollar’s strength or weakness has been a function of interest rate differentials over the past years, the factors that could unseat the dollar as the world’s reserve currency are trumping rates.
As the world’s reserve currency, the dollar has been the benchmark pricing mechanism for most commodities over decades. Saudi Arabia recently ended a 50-year petrodollar protocol to begin pricing petroleum in other currencies.
As the dollar loses its footing, inflationary pressures eroding the U.S. currency will likely take raw material prices higher in dollar terms. Since the February 2022 handshake, which could be the watershed event leading to the dollar’s demise, gold, copper, many metals, cattle, cocoa, orange juice, and other commodities have reached new record price peaks. Others have increased to multi-year highs. The bottom line is that de-dollarization is bullish for dollar-based commodity prices. Two commodity ETF could appreciate if the dollar’s role in the global financial system continues to decline.
The Invesco DB Commodity Index Fund (DBC) and the iShares S&P GSCI Commodity Index ETF (GSG) products own portfolios of diversified commodity futures contracts. At $22.07 per share, DBC had over $1.596 billion in assets under management. DBC trades an average of nearly 960,000 shares daily and charges a 0.87% management fee. At $20.89 per share, GSG had around $904 million in assets under management. GSG trades an average of over 590,000 shares daily and charges a 0.75% management fee. DBC and GSG provide diversified exposure to commodities.
As the currency markets evolve into a two-tier system, the U.S. dollar could temporarily share the reserve currency position with China’s yuan. Still, history teaches that there is only room for one currency at the top of the international podium. If the dollar’s demise continues, expect the commodity bull market to continue.
On the date of publication, Andrew Hecht did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
