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Is the Dollar Doomed? Debunking Myths and Predicting the Future of the US Dollar Index

After the conflict between Russia and Ukraine, the United States and its allies imposed strong sanctions on Russia, confiscated all of Russia’s overseas financial assets, and removed Russia from SWIFT, the first implementation of the weaponization of the dollar, urging non-US currencies to begin to seriously consider whether to seek currency anchors other than the US dollar to ensure financial security. In parallel with the de-dollarization process, there are also countries that plan to implement dollarization, such as Argentina. Indeed, the dollar, as the most important international currency today, will have to bear huge conversion costs if it is to be de-dollarized.

In any case, the U.S. dollar system is facing huge potential challenges, which will inevitably bring about changes in the U.S. dollar index itself, so this article focuses on the pricing logic of the dollar’s pivot trend and short-term fluctuations.

In the medium term, it depends on the economic status of the United States. Since the decoupling of the US dollar from gold, the US dollar index has gone through three cycles, and the corresponding US share in the global economy has also shown cyclical changes. The first cycle was from 1971 to 1985, in which the U.S. dollar index fell for 10 years and rose for 5 years, during which the United States accounted for 30% of the global economy, and the central value of the U.S. dollar index was 109. The second cycle was from 1986 to 2002, in which the dollar index fell for 7 years and rose for 10 years, during which the United States accounted for 28% of the global economy, and the central value of the dollar index was 97. The third cycle is from 2003 to the present, in which the dollar index has fallen for 9 years and risen for 12 years, during which the United States accounts for 24% of the global economy, and the central value of the dollar index is 89.

Judging from the empirical law embodied in these three cycles, firstly, the cyclical center of the US dollar and the proportion of the US economy are slowly declining simultaneously, and the logic behind it can be called the generalization of the Triffin problem – when the US dollar system provides convenient and stable benefits to the world, such as the rise of emerging markets, it virtually weakens the position of the US economy, and the exchange rate, as the comparison of the economy, corresponds to the decline of the US dollar center. Second, the length of the dollar’s cycle is slowly growing. Behind this is the globalization of trade and the associated economic globalization, the need for a stable financial environment, and the increased coordination of monetary policies in various countries. Third, in each cycle, the decline and rise of the dollar are asymmetrical, and in the last two cycles, the rise has been longer than the downside, and the dollar has a single peak in each cycle.

If the empirical law of the dollar reflected in these three commonalities is still valid, then the current dollar cycle is likely to be nearing the end, and the dollar should enter the fourth cycle, that is, into a downward phase. However, the changes in the global supply system triggered by the pandemic and the geopolitical changes caused by the Russia-Ukraine conflict have challenged these empirical patterns.

For example, in the short term, the “smile curve theory” based on empirical data is often used to explain the volatility of the dollar index, that is, when the US economy is significantly better than other economies, the dollar index generally strengthens; When the global economy faces an economic crisis or financial crisis, the U.S. dollar index generally strengthens; The dollar index will weaken only if the US economy underperforms other economies and there is no major crisis.

Since the epidemic, the U.S. dollar index has experienced two “smile” changes, the first was dominated by the epidemic from March 2020 to September 2022, and the second was dominated by the Federal Reserve’s interest rate policy from October 2022 to September 2023. Basically back to the pre-pandemic level and when the Fed started its interest rate hike cycle, the factors leading the change in the US index smile this time are more focused on the US economy itself – whether it can have a soft landing. In view of the fact that the dominant factors that triggered the first two “smile” changes continue to weaken, where the current “smile” bottom of the dollar index will go is undoubtedly one of the important concerns of the current financial market.

Since the U.S. dollar index is based on the “smile curve theory” and depends more on the situation of the U.S. economy relative to other economies, if you want to predict the bottom of the “smile” of the U.S. dollar index, it is necessary not only to deduce the U.S. economy itself, but also to analyze its relative situation.

By the end of 2023, the U.S. CPI, core CPI, PCE, and core PCE have all fallen sharply from their peaks in mid-2022, with declines of 5.7%, 2.6%, 4.5%, and 2.7%, respectively, while the U.S. unemployment rate has stabilized at 3.7%, and by the end of 2023, The ratio of the number of unemployed people in the United States to the number of job vacancies is only 0.3, which is not only lower than the average since the new century (1.3), but also lower than the pre-epidemic level (0.4), and the imbalance between supply and demand in the job market has not been completely reversed.

The impact of the Fed’s interest rate hike on the supply side has not yet been revealed, and it is more manifested in the stabilization of inflation caused by the decline in demand.

In addition, the current US economic data is resilient, with a growth rate of 3.3% in the fourth quarter of 2023, exceeding market expectations. If we take the fourth quarter of 2020 as the base point 100 to observe the growth of real GDP in major advanced economies, the US economy has grown by 8.1% by the end of 2023, which is significantly higher than that of other advanced economies.

Therefore, neither the Fed’s interest rate environment, nor the US economy itself, nor the relative situation, do not support a downward trend in the US index anytime soon, and it is difficult for the dollar index to break below 100 from the bottom of the third “smile” that it is experiencing.

Based on the above analysis, the US dollar will most likely enter the fourth cycle, but it will not fall back soon, that is, the switching period of the US dollar cycle will be longer than before, and the corresponding non-US economies will still suffer the spillover impact of the US dollar.

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