Central banks normally keep the majority of their reserves in US dollars as it is the most trusted, most liquid currency in the world and the US has proven to be a reliable counterparty.
The chart opposite highlights the US dollar against a basket of currencies – with renewed strength in the dollar reflecting the fact that interest rates in the US are now well ahead of those in the UK, Eurozone and Japan.
The chart begs a question: is the dollar index breaking out to new highs or is it peaking at previous highs that have acted as a ceiling since 2015? A couple of fundamentals would point to the dollar index peaking:
- US Government debt as a percentage of GDP is now at 130% and rising.
- The US debt-to-GDP ratio is rising because the US consistently runs a budget deficit. If the US dollar was not the accepted reserve currency of the world, it would struggle as a country to get other countries to fund its budget deficits, thus resulting in a weak US dollar.
So, a key here is the direction of the US budget deficit. If the US is headed into recession, as seems likely, the budget deficit may well deteriorate from here requiring ever more buyers of US dollars.
High US Government debt levels probably preclude the US Federal Reserve from raising interest rates to a level that would actually curb inflation, currently at 8%. So, this makes the situation quite different from the late 1970s, where low levels of US Government debt/GDP (circa 35% at that time) meant that the Federal Reserve could ramp up interest rates to kill off inflation, which, of course, the Fed did indeed do in the late 1970s and early 1980s.
On the other hand, the reversing of quantitative easing by the US Central Bank (the Federal Reserve) is reducing the amount of dollars in circulation. That’s a positive for the dollar index!
So, the key question for us is does this improve the case for gold over the US dollar? We covered this in more detail in a recent newsletter to members of the website. Click the link to subscribe if interested.