US Reserve Currency Status
The hurdle is VERY high for the US to lose reserve currency status
One of the biggest debates in markets right now is whether the fall in the Dollar is cyclical, i.e. a short-term fall that may reverse quickly, or whether its fall reflects more permanent forces, including a loss in reserve currency status. Today’s post argues that the latter is very unlikely on any reasonable horizon, even if the volatility of recent US policy announcements is unnerving and suboptimal.
The fact that markets are even debating US reserve currency status is shocking. This debate has been sparked by the highly unusual fall in the Dollar in the face of tariffs. After all, theory says the Dollar should have risen, as markets see tariffs as a negative shock on other countries. The Dollar should have risen therefore (not fallen).
However, there’s many different forces driving currencies at any one time. As I showed in a recent post, rate differentials have moved sharply against the Dollar, a sign markets have become more pessimistic on US growth. That’s a short-term driver of Dollar weakness that has nothing to do with reserve currency status. My best guess is that markets are conflating this short-term driver (growth) with longer-term fundamentals (reserve currency status).
The IMF runs a quarterly survey on how official foreign exchange reserves are allocated across currencies. The last data point in this survey is Q4 2024, i.e. pre-dates recent market ructions, but there’s still a key point that bears making: in the broad sweep of history, the weight of the Dollar in global foreign exchange reserves (black) is stable around 60 percent. The single biggest potential rival to the Dollar - the Euro (blue) - has a weight of 20 percent and has failed to make any inroads against the Dollar in the almost 30 years since its introduction. The truth is that reserve managers take a very long-term view, which means that the events of recent weeks will take a very long time to translate into any action, if that ever happens.
A few weeks ago, there was speculation China might be selling US Treasuries in its official foreign exchange holdings as retaliation to tariffs. Those rumors crop up periodically and are completely implausible. If there were any truth to such rumors, markets would immediately and violently front-run China, which would cause US yields to jump sharply, leaving China with large capital losses on its Treasury holdings. The truth is that China (and other large holders of US Treasuries like Japan) are stuck. Selling down these holdings without incurring large losses is impossible.
Recent Dollar weakness therefore most likely has little to do with US reserve currency status. Instead, it reflects markets taking a more bearish short-term view on growth in the US vis-à-vis its trading partners. These two things are getting conflated.
I realize interest rate differential is one data point in complex system. But if 6 months ago you knew that US 2y yields would be unchanged while German 2y was 2.15>1.85, would you have placed a bet that $ would decline from 1.05-1.12? Clearly high US rates not enticing $ accumulation.
While I agree it’s likely not today, one day USD will not be the GRC. And if you were going to ask me what kind of policies would eventually lead to that outcome, I’d start with Feb 22 Russia reserve confiscation, toss in some Steven Miran, and run straight through to Liberation Day- exactly the menu I would draw up.
Been following you on X for a while. Like your way of looking at things. Agree with you that the reserve currency status of the $ isn’t going to diminish much too soon. Do you see the USD weakening a lot more like what happened in the period leading up to the GFC?