In spite of our dismal investment landscape, financial cheerleaders still wave their pom-poms and urge you to buy stocks and bonds ‘for the long run’. You only need to look at bond markets to see what I mean.
Short term Treasuries have almost no yield. Long-term Treasuries offer 2% if an investor is prepared to bet on no inflation for 10 years.
High-yield corporate debt is loaded with credit risk at this stage of the cycle. The defaults are going to pile up as we enter a global growth recession in early 2016.
Yet you’re urged to blindly enter this market. Based on assurances that all is well and the next 20 years will echo the past 20 years.
Meanwhile, the financial foundation built on the dollar is rotting away.
The historical precedent for the slow loss of reserve currency status is the strange case of sterling. The story begins with a geopolitical event far removed from the counting rooms of London — the assassination of Archduke Franz Ferdinand, heir to the throne of the AustroHungarian Empire, by a Serbian terrorist in Sarajevo on 28 June 1914.
When the First World War began on 28 July, one month after the assassination of the Archduke, all of the major belligerents immediately suspended the conversion of their currencies into gold except the UK. The conventional view was that countries needed to hoard gold and print money to pay for the war, which is why they suspended convertibility.
The UK took a different approach. By maintaining the link to gold, London maintained its credit standing. This enabled the UK to borrow to pay for the war. It was John Maynard Keynes who convinced the UK to remain on the gold standard. It was Jack Morgan, son of JP Morgan, who organised massive loans in New York to support the British war effort.
Initially there were huge outflows of gold from the US to the UK. Even though the UK remained on the gold standard, investors sold stocks, bonds and land in the US, converted the proceeds into gold, and then shipped the gold to the Bank of England.
In November 1914, the flow of gold suddenly reversed. The British needed US exports of food, wool, cotton, oil, and weapons. All of this had to be paid for either in gold or pounds sterling that could be converted into gold. The gold that had flowed east from New York to London now began to flow west from London to New York.
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From November 1914 until the end of the war in November 1918, there were massive gold inflows to the Federal Reserve Bank of New York and its private member banks. It was at this stage that the dollar emerged as a new global reserve currency to challenge the supremacy of sterling.
The process of the dollar replacing sterling began in November 1914, but there was no immediate or sudden collapse of sterling. Throughout the 1920s, the dollar and sterling competed side-by-side for the role of leading reserve currency. Scholar Barry Eichengreen has documented how the dollar and sterling took turns in the leading role with the lead shifting back-and-forth several times.
But by 1931, the race was becoming one-sided. The dollar was starting to pull away. Winston Churchill had blundered by pegging sterling to gold at an unrealistic rate in 1925. The super strong sterling that resulted decimated UK trade, and put the UK in a depression three years before the rest of the world. UK trade deficits caused Commonwealth trading partners such as Australia and Canada to get stuck with huge unwanted reserves in sterling.
The rise of the dollar, and the steady decline of sterling continued through the 1930s until the start of the Second World War in 1939. At that point, the UK suspended the convertibility of sterling into gold. The international monetary system broke down for the second time in 25 years. Normal trade, currency exchange, and gold convertibility remained suspended until the international monetary system could be reformed.
This reform took place at the Bretton Woods international monetary conference held in New Hampshire in July 1944. That conference marked the final ascendency of the dollar as the leading global reserve currency.
From 1944 to 1971, major currencies, including sterling, were pegged to the dollar. The dollar was pegged to gold at US$35.00 per ounce. Bretton Woods was the definitive end to the role of sterling as the leading reserve currency. The conference enshrined the dollar in the leading reserve currency role — a position it has held ever since.
The point of this history is to show that the replacement of sterling by the dollar as the leading reserve currency was not an event, it was a process. The process played out over 30 years, from 1914 to 1944. It involved a seesaw dynamic in which sterling would try to reclaim the crown only to lose it again.
With hindsight it is possible to see that the turning point took place in November 1914 when gold outflows from the US reversed and became inflows. Those inflows continued until 1950 despite two world wars, and the Great Depression.
Yet, no one saw the collapse at the time.
From the Bank of England’s perspective, November 1914 may have seen gold outflows, but no one believed the process of decline was inevitable or irreversible. The belief in London was that Britain would win the war, maintain the empire, and preserve sterling’s position as the most valued currency in the world.
Britain did win the war, but the cost was too great. They lost the empire and sterling lost its role as the leading reserve currency. The issue for investors today is whether the US dollar already had its November 1914 moment.
Is it possible that the collapse of the US dollar as the leading reserve currency has already begun? The answer is ‘yes’.
Looking at the massive flows of gold to China, the rise of a dollar competitor in the form of the SDR, and the coming inclusion of the Chinese yuan in the SDR basket, it is difficult not to conclude that the dollar collapse has already begun.
Yet, like the collapse of sterling a century ago, the decline of the dollar will not necessarily happen overnight.
It will be a slow, steady process.
Strategist, Strategic Intelligence