Unraveling the Bedrock: The Deterioration of the US Global Currency Reserve System - Part 1

Since the autumn of 2019, I have maintained a pessimistic stance on the strength of the dollar, indicating a longer-term perspective towards a weakened currency.

This viewpoint began to take shape when the Federal Reserve implemented interest rate cuts in the summer of 2019. Subsequently, the perspective gained further credence following a sudden surge in overnight repo rates in September 2019, which compelled the Fed to initiate repo liquidity injections.

I totally agreed with the author's viewpoint in the article "The Most Crowded Trade," which projected a depreciation of the dollar in 2020 and also anticipated that the Fed would likely commence the expansion of its balance sheet by purchasing Treasury securities in 2020, or possibly even as early as the last quarter of 2019 due to oversupply concerns.

Around the similar timing with the article, the Fed indeed announced its intention to initiate Treasury purchases, and as of the present moment, well over a year later, this practice remains ongoing.

The accompanying graph illustrates the performance of the dollar index since then, depicting a decline from approximately 99 to 92.

Moving ahead in the next 3-5 years, my expectation remains that several currencies, including the dollar, will continue to depreciate in comparison to hard assets. During this timeframe, the dollar is likely to be positioned as one of the weaker major currencies, albeit with intermittent counter-rallies that naturally occur.

While it is uncertain whether this trend will persist, thus far, my perspective has proven accurate. The dollar index is presently weaker than it was in October 2019, but the process is still unfolding. The outbreak of the pandemic in the first half of 2020 temporarily boosted the dollar, introducing substantial volatility into the ongoing structural forces rather than altering their overall trajectory.

Regarding the next 3-6 months, I do not hold a definitive opinion due to the presence of solvency concerns until the potential normalization of conditions in the spring or summer of 2021. Additionally, the current market sentiment sees a crowded short position on the dollar. However, as we approach late 2021 and move into 2022, my outlook remains bearish on the dollar.

Taking my perspective a step further, evidence indicates that the global monetary system is gradually realigning itself, which will have significant implications for long-term investments.

This article delves into various concepts encompassing the fraying of the existing petrodollar system, its impact on both US and foreign stakeholders, the emergence of central bank digital currencies, and the potential complete restructuring of the global monetary system.

It is a complex subject to navigate, as there have been countless unsubstantiated claims of an imminent "dollar collapse" over the past few decades. However, this analysis stands apart from such claims, providing a quantitative examination of the current global monetary system's nearly 50-year history since the early 1970s.

The article places particular emphasis on identifying the bottlenecks and issues that have emerged within the system, elucidates why a sustained period of a weak dollar over 3-5 years remains my foundational scenario, and demonstrates how these growing pains appear to be driving a reconfiguration of the global monetary system throughout this decade.

The Framework of the Global Monetary System

Rather than a chaotic jumble, international trade and exchange rates possess a certain structure that is established and enforced by dominant powers during a particular era.

In essence, at any given time, an empire or a group of influential countries collaborate to establish a rules-based global order that governs international trade and pricing.

Nonetheless, any system inherently experiences economic entropy as order gradually gives way to disorder. While global monetary systems can endure for extended periods, they are not permanent. As the center of global power shifts over time and as bottlenecks and flaws in the system reach unsustainable levels, resulting in increasing disorder, the system undergoes a gradual or abrupt reordering into a different system.

Ironically, it is often not an external threat that brings about the downfall of an existing order; rather, it is the internal flaws within the system that, when left unaddressed, eventually expand to a point where they undermine the system, necessitating a reordering either by the incumbent ruling regime or by a new regime that displaces it.

For instance, over the past century, the world has witnessed transitions from the gold standard system to the Bretton Woods system and then to the petrodollar system. Each of these systems primarily unraveled from within rather than being dismantled externally, and each transition was accompanied by significant and widespread currency devaluations.

Gold Standard (pre-1944)

Throughout much of human history, economies were based on trade, where goods and services were exchanged. The introduction of precious metals like gold and silver facilitated this process, as these metals have been regarded as forms of money for thousands of years. With precious metals, one could convert a specific commodity (such as furs) into a universally accepted commodity (like gold and silver, which are scarce, durable, and divisible), enabling the acquisition of desired goods at a later time.

Subsequently, paper currency and credit were introduced as a more convenient layer atop gold. Gold could be securely stored in vaults, and paper notes representing a portion of that gold could be used as a medium of exchange. These notes were sometimes issued by private banks and, in modern times, predominantly issued by sovereign governments. In this sense, governments issued paper currency backed by gold held in central bank vaults.

With time, the concept of global reserve currencies emerged, referring to paper or precious metal currencies of trading or military empires that were recognized and accepted in numerous countries beyond their own borders. Ancient examples include the Roman Empire, followed by notable examples like the Dutch Empire, the United Kingdom, and presently the United States. In the 1800s and early 1900s, the United Kingdom's currency held the most global recognition, albeit within a system where multiple currencies were backed by gold.

During these centuries, Europe primarily served as the center of global power, with its precise epicenter shifting over time. Wars within Europe played a significant role in the eventual replacement of the dominant power.

Under the gold standard system, exchange rates between currencies still fluctuated over time due to various reasons, with the balance of payments serving as a key factor. The article titled "Why Trade Deficits Matter" provides in-depth insights into the reasons behind this phenomenon. Essentially, when a country persistently imported more than it exported, it faced the risk of gold outflows and economic stagnation within its borders. However, this state usually self-corrected through a recession that eventually led to currency devaluation, making exports more competitive and imports more expensive, thereby realigning the export-import balance.

In the later stages of this system, major nations significantly devalued their currencies and either reset or suspended their gold pegs.

Both the victors and the defeated nations of the world wars engaged in currency devaluation, although the extent of devaluation was comparatively lesser for the winners. This devaluation resulted from a combination of the wars themselves and the culmination of the long-term debt cycle.

Bretton Woods System (1944-1971)

The transfer of global reserve currency status began gradually after World War I and was solidified in the later stages of World War II. With the wars and the ascent of the American economy, the center of global power shifted from Europe, particularly the United Kingdom, to the United States.

In the 1930s, the United States government made gold ownership illegal and compelled citizens to sell their gold to the government, resulting in the accumulation of substantial gold reserves. Furthermore, many countries sent their gold to the United States to ensure its safety during the war. Consequently, the United States possessed a massive gold stockpile and served as the custodian of gold for numerous allies worldwide.

As World War II unfolded, while Europe and East Asia suffered severe devastation, the United States homeland remained relatively unscathed, leading to the United States becoming the world's largest creditor nation. It was during this time that the Bretton Woods system was established. Under this system, the United States backed its dollar with gold, and numerous other countries pegged their currencies to the U.S. dollar, effectively adopting a gold standard. Many countries held U.S. Treasuries as reserve collateral, considering them as valuable as gold. Although the dollar was not redeemable for gold by U.S. citizens, it could be redeemed for gold by foreign governments.

During this period, the United States also laid the foundation for its alliance with Saudi Arabia, which would become significant in the subsequent system.

Additionally, the emergence of the "eurodollar market" occurred during this time. This term refers to the dollar market that operated outside the United States and beyond the jurisdiction of the Federal Reserve. Primarily centered in Europe but extending globally, this market played a crucial role in the Bretton Woods system and the subsequent petrodollar system.

With the Bretton Woods system and the succeeding petrodollar system, the United States achieved a near-global dominance over the international monetary system. Previous imperial currencies had never attained such a comprehensive financial grip on the world, thus making them "widely recognized and dominant" currencies rather than true "global reserve" currencies. Therefore, the status of the dollar as the global reserve currency since 1944 cannot be directly compared to pre-1944 periods of other global reserve currencies.

In other words, this period was rather exceptional. It marked the first time in history when technology allowed the entire world to be interconnected to the extent that a truly global war could occur and be followed by a truly global monetary system.

However, after only a decade, the Bretton Woods system began to show signs of strain. The United States started to run significant fiscal deficits and experienced a moderate rise in inflation, initially due to domestic programs in the late 1960s and later exacerbated by the Vietnam War. As a result, the United States witnessed a decline in its gold reserves, as other countries began to question the backing of the dollar and opted to redeem their dollars for gold instead of holding onto them with confidence.

The following chart illustrates the decline of U.S. gold reserves measured in metric tonnes:

Indeed, the data clearly indicates that the global monetary system established by the United States was inherently unstable right from its inception. Initially, the United States possessed more gold than its foreign liabilities, but this gap started to narrow rapidly within the first few years.

By the late 1950s, the United States found itself in a situation where its external liabilities surpassed its gold reserves. The turning point marking a significant problem occurred in the mid-1960s when the portion of US external liabilities owed to foreign officials exceeded the country's gold reserves. This development signaled a critical stage at which the system became deeply troubled. Eventually, in 1971, the system collapsed, and the United States defaulted on its obligations.

`Chart Source: BIS Working Papers No 684`

The monetary system had an underlying flaw that, when left unaddressed, led to its demise. It was fundamentally unsustainable in its original design. The United States faced a challenge in maintaining sufficient gold reserves to back its domestic currency while also supporting the expanding global use of its redeemable currency.

Economists like Robert Triffin explicitly warned about this issue, known as the Triffin dilemma, to Congress and the business world. It was a problem that could be foreseen. A similar situation occurred with the United Kingdom before World War I.

John Keynes also recognized this problem in advance and proposed an alternative system called the Bancor. It involved using an international unit of account based on gold and a basket of major currencies to settle trade balances and hold as a central bank reserve asset. This would have provided a more balanced system with a neutral settlement mechanism, rather than relying solely on one country's currency.

However, political considerations often outweigh sound economic principles, and the Bretton Woods system gained more support than alternative ideas initially. The International Monetary Fund (IMF) did introduce a similar concept called Special Drawing Rights (SDRs), which are units based on a basket of major currencies held by central banks. However, SDRs did not gain widespread support and were only adopted to a limited extent.

In 1971, the mathematical realities caught up with the Bretton Woods system, and Richard Nixon ended the convertibility of dollars into gold, effectively terminating the system. Although the closure of gold convertibility was initially intended to be temporary, it eventually became permanent. Instead of transitioning to another country, the United States was able to reshape the global monetary system, with itself still at the center, in the subsequent system.

As a result, major currencies, including the dollar, experienced significant devaluation against gold and other hard assets in the 1970s. This devaluation of currencies often accompanies the restructuring of the global monetary system. The same factors that lead to the breakdown of the system also contribute to the devaluation of currencies. Consequently, the broad money supply increases significantly, and the purchasing power of existing debts is partially eroded through inflation.

Petrodollar System (1974-Present)

Starting in 1971 after the breakdown of the Bretton Woods system, all currencies worldwide transitioned into fiat currencies, resulting in a less regulated global monetary system. This marked the first instance in human history where all currencies simultaneously lost their backing and became mere unbacked paper.

A "fiat" refers to an authoritative decree issued by an individual or institution in power. Fiat currency is a monetary system where the currency itself holds no inherent value; it is essentially paper, inexpensive metal coins, or digital bits of information. Its value is derived from the government's declaration that it has value and is legally accepted as a means of payment for all transactions, including taxes.

A country can enforce the use of fiat currency as a medium of exchange and unit of account within its borders by mandating that all taxes must be paid in that currency or by implementing laws that restrict or even prohibit other forms of exchange and accounting units. However, if a country's currency faces significant challenges, as is often the case in many emerging markets, a black market may arise for other forms of exchange, such as foreign currency or tangible assets.

Fiat currencies encounter specific difficulties when attempting to be used beyond their home country. Why would businesses and governments in other countries accept pieces of paper that can be endlessly printed by a foreign government and have no tangible backing as a form of payment for their valuable goods and services? Without real backing, what is the true worth of such currency? Why would one sell oil to foreigners in exchange for paper?

In the early 1970s, various geopolitical conflicts, including the Yom Kippur War and the OPEC oil embargo, took place. However, in 1974, the United States and Saudi Arabia reached an agreement, leading to the establishment of the petrodollar system—a clever approach to make a global fiat currency system function reasonably well.

While we consider this arrangement normal nowadays, this five-decade period of global fiat currency is extraordinary and unprecedented in historical terms. Imagine designing a way to make an all-fiat currency system work on a global scale for the first time in human history. To achieve this, one would have to somehow convince or compel the entire world to trade valuable assets for foreign pieces of paper without any guarantee from the issuing governments that those papers hold any specific value in relation to a certain amount of gold or other tangible assets.

Under the petrodollar system, Saudi Arabia (as well as other OPEC countries) exclusively sells its oil in dollars in exchange for U.S. protection and cooperation. Even if a country like France wants to purchase oil from Saudi Arabia, it must do so using dollars. Any country in need of oil must acquire dollars to pay for it, either by earning them or exchanging their currency for dollars. Consequently, non-oil-producing countries also sell a significant portion of their exports in dollars, despite the fact that the dollar is essentially a fiat foreign currency. They do so in order to obtain dollars to purchase oil from oil-producing countries. Furthermore, all these countries accumulate excess dollars as foreign exchange reserves, with a large portion being invested in U.S. Treasuries to earn interest.

In return, the United States employs its unrivaled blue-water navy to safeguard global shipping routes and maintain the geopolitical status quo through military action or the threat thereof when necessary. Additionally, the United States must consistently run trade deficits with the rest of the world to ensure an adequate supply of dollars in the international system. However, many of these dollars are recycled into the purchase of U.S. Treasuries and held as foreign exchange reserves. Consequently, a substantial portion of U.S. federal deficits are financed by foreign governments, in contrast to other developed nations that primarily rely on domestic financing. This article provides an explanation of why foreign financing can be beneficial while it is happening.

The petrodollar system is ingenious because it was one of the few ways to make the entire world accept foreign paper currency in exchange for tangible goods and services. Oil producers receive protection and stability in exchange for pricing their oil in dollars and investing their reserves in U.S. Treasuries. Non-oil-producing countries require oil and, therefore, need dollars to obtain it.

This leads to a disproportionate amount of global trade being conducted in dollars relative to the size of the U.S. economy. In a sense, the dollar is indirectly backed by oil without being explicitly pegged to a defined ratio. The system creates a persistent global demand for the dollar, while other fiat currencies are primarily used domestically within their own countries.

While the provided chart is two years old, the general situation has not significantly changed since then. It demonstrates that despite the United States accounting for only approximately 11% of global trade and 24% of global GDP in early 2018, the dollar's share of global economic activity was much higher, ranging from 40% to 60% depending on the metric used. This discrepancy reflects the dollar's status as the global reserve currency and its critical role in global energy pricing.

Similar to the flaw observed in the Bretton Woods system, the petrodollar system also possesses an inherent flaw, as mentioned earlier. Namely, the United States must maintain persistent trade deficits, leading to a recurrence of the Triffin dilemma. While this approach can be sustained for a considerable period, it is not a viable long-term solution.

Instead of depleting our gold reserves, a different consequence of the petrodollar system is the gradual erosion of our domestic manufacturing sector, which is gradually replaced by foreign production.

Typically, when other countries experience trade deficits, their currency tends to devalue, making their exports more competitive and imports more expensive. This mechanism helps prevent the accumulation of extreme trade imbalances over long periods. However, due to the persistent international demand for the dollar created by the petrodollar system, the trade deficit of the United States remains uncorrected and unbalanced. The structural design of the global monetary system perpetuates this open trade deficit, leading to a permanent imbalance that, over time, becomes a flaw capable of undermining the system.

Another flaw of the system is its encouragement of mercantilism. This incentivizes trade partners to maximize their exports and minimize imports by manipulating their currencies to weaken them. Since most currencies are fiat and have floating exchange rates, many countries purposefully keep their currencies weak. This strategy allows them to maintain a positive trade balance with the United States and other trading partners. While countries aim to avoid excessively weak currencies that hinder imports, they strive for weak currencies to boost export competitiveness and limit import purchasing power, thus enabling trade surpluses. This approach facilitates rapid industrial production growth and the accumulation of reserves and dollars. However, as the global reserve currency, the United States is excluded from this option, leaving us burdened with persistent trade deficits.

Certain segments of the population, particularly those in higher income brackets, directly or indirectly benefit from this system. Americans working in finance, government, healthcare, and technology enjoy the advantages of living in a hegemonic power without experiencing the drawbacks. Conversely, individuals engaged in physical product manufacturing tend to lose their jobs or face suppressed incomes, missing out on the benefits. Outside the United States, exporting countries benefit from this system, while countries dissatisfied with the structure of the global monetary system have limited options for recourse unless they reach a significant size comparable to Russia and China.

The Cycle of Petrodollar's Rise and Fall

Since the implementation of the petrodollar system in 1971, exchange rates have been freely floating, allowing the value of the dollar to fluctuate significantly against other currencies. This also means that different currency pairs can strengthen or weaken relative to one another.

When the value of the dollar starts to decline, financial media often publishes articles speculating about the "potential loss of the dollar's global reserve status." However, it is important to understand that these concepts should be treated separately. The dollar has experienced two major bear market drawdowns of over 40% against a basket of major currencies within the existing monetary system, without losing its global reserve currency status. Therefore, being bearish on the dollar within the current petrodollar system does not necessarily imply a belief that the system itself is coming to an end.

The provided chart illustrates the performance of the dollar index since the inception of the petrodollar system in the early 1970s. It compares the value of the dollar against a basket of major currencies and highlights the three major cycles it has undergone.

This year, the dollar index fell below its 50-month moving average, which now shows a slight downward tilt. This raises the possibility of another downward movement similar to what occurred after the previous two major cycle tops.

It is important to distinguish between holding a bearish view on the dollar and believing that the global monetary system will undergo structural changes. These two perspectives do not necessarily go hand in hand, although they can be interconnected. Treating these ideas independently is crucial because, although I personally hold both views across different timeframes, they are not the same.

Furthermore, being the world's reserve currency does not automatically shield the dollar from significant fluctuations relative to other currencies. In fact, due to the extensive integration of the dollar into the global financial system, it can experience larger swings both to the upside and downside than it would otherwise.

Contributing Factors to the Cycle

The cycle of the dollar is influenced by significant shifts in monetary and fiscal policies, as well as the resulting capital flows seeking favorable economic conditions worldwide. At the core of this cycle lies the current structure of the global monetary system, known as the petrodollar system.

Countries and companies outside of the United States have accumulated substantial amounts of dollar-denominated debt (estimated at $13 trillion by the BIS). Additionally, they hold even larger amounts of dollar-denominated assets (around $42 trillion according to the IMF and US BEA). These debts and assets have accumulated over decades as a result of countries running trade surpluses with the United States and the widespread use of the dollar in global financing deals, particularly in emerging markets.

This accumulation of dollar-denominated debt creates a consistent demand for dollars to service these obligations. During periods of economic recession or slowdown in dollar-based global trade, there can be a scramble for dollars, which may be in short supply outside of the United States. This scarcity can lead to an international spike in the value of the dollar. We witnessed such a scenario in March 2020 when the COVID-19 pandemic caused a sharp decline in global trade and oil prices.

In this sense, the petrodollar system has reinforced itself over time. Initially, countries needed dollars to purchase oil. However, as international financing increasingly relied on the dollar, countries now require dollars to service their dollar-denominated debts. Thus, the dollar is backed by both oil and dollar-denominated debts, creating a strong self-reinforcing network effect. Importantly, most of these debts are not owed to the United States but rather to other countries. For instance, China, Europe, and Japan extend numerous dollar-based loans to developing countries.

When the dollar strengthens against the local currencies of emerging market countries, it effectively tightens monetary conditions for those countries. This is because their dollar-denominated debts increase in local currency terms relative to their assets and cash flows, which can be particularly harsh during economic recessions. This is one of the reasons why emerging market economies and assets are considered riskier and more volatile compared to developed market economies, mainly due to their dollar-denominated borrowings.

Conversely, a weakening dollar can act as a form of quantitative easing for emerging market countries. It eases their debt burden relative to their local-currency cash flows and assets.

Similarly, dollar-denominated assets, especially those held by foreign governments and central banks accumulated through trade and current account surpluses, serve as collateral to defend their currencies or assets that can be sold to obtain dollars to meet their obligations when necessary.

During periods of a weak dollar, a global economic boom often ensues, benefiting nations worldwide, including the United States. If nations act prudently, they accumulate substantial foreign exchange reserves with their dollar inflows. Within the petrodollar system, this typically involves purchasing US Treasury securities. Additionally, countries often utilize this period to acquire dollar-based loans, which can have adverse consequences in the future.

In contrast, during periods of a strong dollar, the global economy tends to slow down, and nations find themselves squeezed by dollar-denominated debts. They reduce their purchases of US Treasuries, and in some cases, may even sell them to obtain dollars to service their dollar-denominated debts or manage their currencies.

As a result, a clear pattern emerges between the strength of the dollar and the percentage of US federal debt held by foreign entities. When the dollar enters a significant bull run, foreign holders of US debt face challenges, global growth slows (including that of the United States due to global economic interconnections), and foreign entities reduce or halt their purchases of US debt.

The provided chart displays the trade-weighted dollar index in blue (with a newer index in red spliced onto it due to the discontinuation of the longer-running index in early 2020) and the percentage of US federal debt held by foreign entities in green:

As depicted in the chart, during each of the three major bull runs of the dollar index, there was a significant decrease in the percentage of US federal debt held by foreign entities. Despite the ongoing issuance of debt by the United States, foreign investors were not actively purchasing a substantial amount of it.

This lack of foreign buying places the responsibility of funding the US federal deficits on the US itself. This means that either the private sector or, increasingly, the Federal Reserve has to step in and purchase Treasuries. Eventually, this situation leads to a shift towards dovish monetary policy in the US, which contributes to the weakening of the dollar and initiates a new cycle.

For the second chart, we can examine the relationship between the dollar index and US corporate profits. It becomes evident that during each of the significant dollar bull runs, corporate profits remain stagnant in dollar terms for several years. This highlights the impact of the dollar's strength on the profitability of US corporations during these periods:

Put simply, the global economy operates in an interconnected manner. When the dollar strengthens, the United States, along with other regions, often encounters economic challenges. A strong dollar makes US exports less competitive and leads to a sluggish global trade environment. Consequently, this results in domestic stagnation within the United States.

During the dollar spike in the 1980s, the global debt levels were comparatively lower, necessitating deliberate intervention to reverse the situation. However, the second and third dollar spikes occurred in an environment of higher debt, both in the US and other parts of the world. As a result, these spikes were more self-correcting without requiring global coordination. The US Federal Reserve unilaterally implemented shifts in monetary policy to safeguard the US Treasury market and stimulate the domestic economy.

1980s Dollar Cycle

Following the abandonment of the gold standard in the 1970s, the dollar experienced weakness, leading to rapid consumer price inflation in the United States and many other countries. In the early 1980s, Paul Volcker, the new chairman of the Federal Reserve, raised interest rates significantly to combat inflation. Concurrently, Ronald Reagan implemented fiscal policies involving tax cuts and increased spending, contributing to an economic boom. This combination of tight monetary policy and loose fiscal policy tends to strengthen a currency while it persists.

The first half of the 1980s witnessed a rapid strengthening of the dollar, which had repercussions such as the Latin American debt crisis. Countries in Latin America, burdened by dollar-denominated debts, faced difficulties in repaying them, leading to defaults, recessions, and currency crises.

Due to relatively low debts within the United States, Volcker was able to maintain high interest rates for an extended period, providing further impetus to the dollar's bull run. The dollar eventually reached its peak in 1985, when the United States and four other major countries (Germany, Japan, United Kingdom, and France) agreed upon deliberate dollar weakening in an event known as the Plaza Accord. The objective was to enhance the competitiveness of American and European exports against Japanese exports, which were dominating global trade at the time.

As the dollar declined in the late 1980s and the yen strengthened significantly, capital flowed into Japan, contributing to the well-known Japanese equity and real estate bubble, bolstered by the country's robust overall economy.

1990s/2000s Dollar Cycle

The Soviet Union fell in 1991, leaving the United States as the world’s sole superpower, and led to a period of opening markets and rapid globalization. In the early 1990s, the United States had a recession, and saw a period of declining interest rates, and the dollar was weak overall. Emerging markets had a strong period until the mid-1990s.

At that point, the United States’ economy began to do well and raised interest rates, beginning the second dollar bull run. In addition, the US baby boom generation reached its peak working age, resulting in the highest level of labor participation in US history:

In the latter part of the 1990s, the United States experienced a period of booming technology industry, often referred to as the tech boom or bubble. This led to a spike in the value of the dollar. However, this period also brought about significant challenges for several emerging markets, as they faced severe issues stemming from dollar-denominated debts. These difficulties culminated in the 1997 Asian financial crisis and the subsequent 1998 Russian financial crisis. The impact of these crises was felt across emerging markets, with the epicenter of the turmoil located in Southeast Asia. This situation mirrored the Latin American debt crisis of the 1980s but had a distinct focus on Southeast Asia.

The degree to which emerging markets are affected in a given cycle is influenced by the ratio of their dollar-denominated debts to their foreign exchange reserves. The most vulnerable nations to financial crises are those with high levels of dollar-denominated debts and low reserves, while those with substantial reserves and lower debts are better protected.

By 2000, the dotcom equity bubble in the United States started to deflate, prompting the Federal Reserve to lower interest rates. In the subsequent years throughout the 2000s, the dollar experienced a notable weakening, coinciding with a significant boom period for emerging markets. The term "BRIC" gained popularity during this time, referring to Brazil, Russia, India, and China. These countries, characterized by large populations and rapid growth rates, were seen as increasingly influential on the global economic stage.

2010s/2020s Dollar Cycle

The dollar experienced a period of weakness following the global financial crisis of 2008/2009, with a brief spike during that time due to falling oil prices and a global recession. The Federal Reserve implemented three significant rounds of quantitative easing to stimulate the economy, which concluded in late 2014.

Between 2014 and 2015, as the Fed shifted towards tighter monetary policy by ending quantitative easing, the dollar rapidly strengthened, marking the onset of the third major dollar bull run. Consequently, several emerging markets faced severe recessions from 2014 to 2016.

In 2016, the dollar reached its peak, leading to discussions about a secret Shanghai Accord aimed at weakening the dollar, reminiscent of the well-known Plaza Accord of 1985. As anticipated, the dollar indeed weakened significantly throughout 2017, coinciding with a period of "global synchronized growth" where the United States, Europe, Japan, and emerging markets all experienced robust economic performance.

In early 2018, the Federal Reserve commenced quantitative tightening by reducing the size of its balance sheet, causing the dollar to regain strength. However, unlike the previous two cycles, the dollar's decline from peak to trough was only around 12% and did not experience a massive 40% drop. By mid-2018, global growth began to slow both in the United States and other parts of the world. In essence, the period of dollar weakness turned out to be a temporary setback, and the dollar remained strong.

Countries such as Argentina and Turkey faced currency crises during this time, primarily due to their high levels of dollar-denominated debt and limited foreign exchange reserves. In contrast, countries like Thailand, South Korea, Malaysia, and Russia, which suffered during the late 1990s dollar bull run, learned from their previous experiences. They entered this cycle with substantial foreign exchange reserves and reduced dollar-denominated debt, providing them with greater resilience against a strong dollar.

By the summer of 2019, the Federal Reserve began cutting interest rates in response to slowing economic growth. In September 2019, there was a spike in the overnight lending rate in the US banking system, prompting the Fed to supply repo liquidity and eventually engage in Treasury bill purchases and balance sheet expansion. This marked the end of quantitative tightening and a shift towards quantitative easing.

The strong dollar had contributed to a slowdown in global GDP growth, including in the United States, prompting the Fed to lower interest rates. Additionally, with foreign investors buying fewer Treasuries due to the strong dollar, domestic US balance sheets became increasingly saturated with Treasuries, necessitating the Fed's shift from quantitative tightening to quantitative easing to purchase a significant amount of Treasuries and inject liquidity into the system.

The dollar subsequently weakened again as expected. However, in early 2020, the COVID-19 pandemic struck, leading to a halt in global trade and a collapse in oil prices, exacerbated by a structural oversupply issue. As a result, the dollar quickly spiked, with foreign investors selling off Treasuries and other US assets to obtain dollars. This caused the Treasury market to become illiquid, leading the Fed to describe it as "ceasing to function effectively." To address this, the Fed lowered interest rates to zero, implemented massive quantitative easing measures, and the US government enacted significant fiscal stimulus.

The dollar started weakening again in response to these actions, and the future trajectory of the dollar remains uncertain as we move forward.