Dollar, dollar, toil and trouble

The US dollar has been the world’s reserve currency for 80 years. When you are king, the only question is when you will stop being so. The fact that power is questioned periodically shouldn’t be a surprise.

Viewed in binary terms, the dollar is unlikely to lose its reserve-currency status anytime soon. As John Ikenberry’s, Power, Order and Change in World Politics made clear, systemic global change generally comes through conflict or its aftermath.

Many of the world’s institutional arrangements came in the wake of the second world war, including the $US’ rise to reserve currency status. The British pound lost its status after the first world war.

But the $US is now shifting form. This will have wide-ranging effects.

Vulnerability

The $US is starting from a position of valuation vulnerability. The currency is around its highest levels since 1986 in real trade-weighted terms. At peak $US, Alabama’s gross domestic product per capita was higher than the United Kingdom or Italy.

At around 45 per cent of global market capitalisation, the US equity market seems disproportionately large relative to the US’ 25 per cent of global GDP. At a record high 72 per cent of developed equity markets, the US seems positively Icarian. The sun can’t be far away.

The US is not twice as productive as the rest of the world, but its companies are globally successful. If tariffs are permanent, that US commercial outperformance will almost certainly erode over time.

The $US is also less cyclically safe. As the reserve currency, it is still the funding currency for the global financial system. When deleveraging eventuates, as it does in periods of stress, the $US will tend to appreciate.

But this funding premium is manifesting less often, with the global financial system much safer today than previously, largely as a consequence of the tightening in financial sector regulation over the last fifteen years.

Until 2017, the US was a net importer of oil, which gave the dollar some anti-cyclical characteristics. The US’ terms of trade (export prices relative to import prices) often rose during global downturns, but the US became a net oil exporter in 2017 and that relationship flipped.

Investors now also pay a premium to buy US government bonds, similar to the UK’s experience of the last three years. Tariff revenue was never likely to fill the US’s fiscal shortfalls, and that has now been confirmed. The US’ budget and current account deficits are both larger than the UK’s.

Solvable

While the US’s fiscal trajectory is unsustainable, it does seem to be more easily solvable than France’s, for instance. US default risk is still very low.

France’s government expenditure is 57 per cent of gross domestic product (GDP) and revenue 52 per cent. Cutting the former is proving politically punishing. Its revenue level, as the highest among Organisation for Economic Co-operation and Development  (OECD) countries, must surely be running into natural limits as a tool for improving the fiscal balance.

But the US’ expenditure is at 36 per cent of GDP and revenue 29 per cent. Only five of 38 OECD economies have a lower revenue share than the US. It’s not apparent the US has a spending problem, but it does have a problem with excessively low revenue. The political will to raise the level of revenue is missing, but financial reality might change that in time.

Until such will manifests, US bond yields are likely to be more upside-sensitive to poor fiscal news and less downside-sensitive to a weaker economy. This will pressure corporate funding costs at inopportune times of the cycle, particularly if credit spreads are widening as well.

In sum, the $US depreciation during 2025’s tariff stress is likely to be more of the new normal. This changes much. The stronger Indonesian rupiah has created the space for Indonesia, for instance, to reduce interest rates in a turbulent period that might normally have prevented monetary policy action.

It also suggests elsewhere, such as Australia and New Zealand, a weaker currency is unlikely to be the shock absorber it once was. This puts more pressure on domestic monetary policy.

Shakespeare’s most famous play is about the tragedy of political hubris. The three bond markets sending messages about the limits of fiscal ambition – the UK, US and Japan – are also joined by divided bodies politic. The dollar is still the reserve currency, but – and with apologies to the Bard – trouble is brewing.

Richard Yetsenga is Chief Economist at ANZ