A Structural Break in the Global Economy
There is No Going Back for a Generation
The Trump administration has undermined decades long trade, defence, payments and reciprocity agreements, and compromised the founding principles of the nation. Whether the US$ can remain the global payments and reserve currency is the most important issue in global finance, presenting practical challenge for foreign exchange management.
The US$ has been at the centre of global finance since the Bretton Woods agreement, signed in July 1944. The world’s acceptance of US$ dominance went hand in hand with US security alliances and a mutual desire to expand global trade and post-war reconstruction.
The emergence of the US$ as the global reserve and payments currency created excess demand for US$’s, putting upward pressure on the dollar. The presence of the US trade deficit leads less sophisticated actors to believe the US$ is overvalued rather than signaling excess aggregate demand. The current administration believes US$ overvaluation is both a cost to the economy and a constraint on domestic policy goals.
At the same time, excess demand for dollars needs to be absorbed by the US treasury market, so delivering lower interest rates, often dubbed a “safety” premium as in times of global crisis capital has flowed to the US even if it was the cause of trouble. This tended to put upward pressure on the dollar and downward pressure on interest rates. Not anymore.
The Trump administration has chosen a coercive approach to foreign relations and an authoritarian approach to domestic policy, the former necessary to gain compensation from its perception of an unfair international trading framework, and the latter to push through domestic policy goals. This came as a shock even though it was well telegraphed in the election campaign, a shock beg enough to upend relative asset price relationships.
The foreign exchange market has an uncanny ability to price structural changes in the relationship between countries. The FX market is telling us the US is no longer considered a safe haven for non-resident assets, so the dollar now goes down in response to policy surprises and interest rates now go up, reversing decades of predictable relative price action. The emergence of a negative correlation between bond and US$ returns on the declaration of trade war has yet to show clear signs of reversal. The market is thus discounting a wholesale change in the US$’s role in the global financial system.
The coercive application of tariffs and non-tariff trade constraints will lead to a reduction in the US trade footprint, and the dollar’s international role will diminish. Both the economic withdrawal from global trade and the bad faith actions of the administration, internationally and domestically, gives other countries no alternative but to protect themselves against US malevolence. They will trade more with themselves and less with the US, so reducing the need for the US$ as a payments currency and the need to park excess balances in US treasuries.
The central international stabilizing role of the US authorities must also be questioned. The US administration has put significant pressure on the Federal Reserve to lower interest rates, so far to no avail. But the Fed has been constrained by a presidential executive order demanding that Trump have control over all regulatory actions the Fed might take. This implies that the fidelity of the US to international financial agreements, of which the Fed is the central player, is now at the whim of the president.
One must assume that the prior availability of US$ liquidity by foreign central banks cannot be assured. The US administration is also promoting Stablecoin as a payments vehicle ,and is pushing the integration of crypto into the existing financial system. This raises the probability of a disruptive systemic event. If the Fed is constrained from freedom of action to stabilize an incipient financial crisis then other sovereigns must reduce US$ exposure. No wonder other central banks are encouraging their commercial banks to minimize their reliance on the US$ mindful of the 2008-2009 crisis when international banks became national in death.
What’s the Alternative?
The US under Trump has systematically undermined its security, trade, and financial agreements in pursuit of zero-game monetization of international relations. The lesson is that any agreement with this administration will sour as quickly as unrefrigerated milk.
Yet many investors cling to the comforting assumptions provided by an eighty-year-old ancien regime that played by the rules and evolved slowly. They would rather bet on this rather than adapt to the current chaos. While investors have taken note, it is hard to review assumptions and change beliefs about how the world works lest you take action that may prove costly. Many want to believe the dollar’s dominant world role will remain intact, and besides there is no alternative reserve and payments currency.
The much-followed Torsten Slok, Chief Economist at hedge fund Apollo Global Management, cheerfully implies that concerns about the US$’s role in the world are not pressing. He cites the size of the domestic US economy, the importance of US economy in international trade, the size, depth, and openness of US financial markets, the convertibility of the currency, and the stability of US domestic macroeconomic policies. So we’re good right? Nothing’s changed right? And, if there’s no competing substitute then we don’t have to change our assumptions do we? We merely need to be alert to unanticipated policy changes. Yet these comforting US parameters are merely sufficient conditions for the status quo.
Values not Economics Build Solid Foundations
Barry Eichengreen, author of Exorbitant Privilege, the Rise & Fall of the US$ and the Future of the International Monetary System takes a subtle but more powerful perspective on the dollar’s challenges. Eichengreen identifies the necessary conditions, beyond the sufficiency of market depth and economic presence, for the dollar dominance to prevail.
Values matter more; the domestic assault on the country’s legal system, its civil service, its universities and health sciences, selective adherence to the rule of law, and the overall corruption of public life all signal institutional collapse. This deviation in values from former democratic allies creates an imperative for those countries to reduce the intensity of their economic and financial engagement with the US.
The world watches the bad faith actions of the US administration with dismay. Recent moves to end the equivalent tax treatment of residents and non-residents signals that equal defence of property rights for non-residents cannot be assumed. Essential to the generation of profits is equal protection of property rights lest you find yourself defenestrated.
Wariness towards future arbitrary actions by the US, notably respect for the rule of law and the predictability of contracts, must surely eclipse Torsten Slok’s blithe assumption that the lack of alternatives leaves the dollar’s dominant role intact. If the sovereign decides the law, then the US will have departed from the shared values of predictability and safety upon which the US sponsored global financial and trading system was built.
To assume the dollar will remain dominant because there is no alternative assumes that the underlying trade and financial arrangements are fixed. But how can this be? Practically the US retreat from global trade will diminish the need to price in US$’s and transact in US$’s so demand for other currencies will rise as demand for dollars falls. Other countries will surely be unwilling to engage given the breach of trust by the US, building on the efforts of others to avoid the dollar area following the weaponization of the Swift payments system to achieve US foreign policy objectives. The US no longer differentiate friend from foe. All are fair game in this a most dangerous game.
Goodbye Inflation Targeting & Sound Regulation
The most important factor for foreign exchange management is the end of Federal Reserve independence. This cannot be understated. The embrace of heterodox economic policies with the passage of the GENIUS Act and the repression of regulation on the behest of the crypto world is a red rag to a financial crisis bull.
Constraints on Fed regulatory action and the exit of Jay Powell in 2026 — if not earlier — demands an assessment of whether the US is now on a path to accelerating inflation. Moreover, an even more fundamental question is whether the US$ still qualifies as a suitable payments currency in the international arena.
The Federal Reserve may have an inflation target, but given the administration’s disruption to institutional integrity will it be able to deliver it? The inflation target is set and owned by the government, but meeting it is contracted-out to an independent central bank. The latter can make cold hard technocratic decisions unrelated to the political cycle and so can induce pain if necessary to keep inflation on target. If you can’t meet the target then it hasn’t any value. Monetary policy becomes unmoored of one framework is discarded into a vacuum.
Two developments suggest that the Fed will be unable to meet its inflation target in the future. The first is that Trump doesn’t want to meet the inflation target, as it is remote from his desire to have low interest rates. He has already ended the contracting out arrangements, we just haven’t noticed. Like all other US federal appointments, the composition of Fed interest rate decision makers will be reconfigured one retirement at a time to anoint rubber stamping appointees that deliver the President’s whims and wishes rather than policy integrity.
The second more distant development, but one that is nearer than imagined, is the explosion in US debt and the potential for higher financing costs to induce a financial crisis. The current share of US debt satisfied by foreign investors will likely become more expensive. If so, then the Fed may have to do more QE to finance the US treasury. If it has a fiscal target rather than a monetary target, such capture of the Fed will make it impossible to keep inflation near 2%
Dollar dominance led to the emergence of large dollar holdings outside of the US, and to ensure that offshore financial instability did not rebound on the US, the Federal Reserve established US$ swap lines with other central banks. Ability of non-US central banks to access the Fed discount window both reduced the probability of financial crises and their severity. Given that Trump now holds a veto over the Fed’s independent exercise of non-interest rate actions, can other countries whose banks have large dollar balance sheets rely on the ability to draw down on the swap lines? And if not, then they need to minimize their economic exposure to the dollar.
Given these significant developments, does the US$ continue still qualify as an international payments currency? There are three abstract tests that determine currency acceptability: it must be information insensitive, meaning we don’t have to do due diligence about its value when we use it to transact. It must be issued by any central bank that has equivalent value at a given exchange rate, or “singleness”, and it has integrity – users can trust the sovereign that issues it.
The US$ is no longer information insensitive for international users given the decay in the institutions of the US state. Potential constraints on access to central bank dollar swap lines threatens singleness and the relative stability of exchange rates, and the coercive behaviour towards other countries and the degradation of public life means the currency lacks integrity.
The dollar looks shaky as a global payments currency.
Multiple Currency Areas and Reserves
To ask for a dollar alternative is to assume the world is as it was. Maurice Obstfeld in a recent paper notes “the parallel Trumpian offensives on international and domestic fronts threatens all the major foundations on which dollar dominance has relied.” He sees an inevitable retreat from the dollar as the world fragments.
Prior to the US$’s dominance, the dollar’s role in global transactions was, in the 1930’s, shared with sterling and the franc. The past has seen the world function with multiple currency areas in an economically fragmented world, often based on political and military alliances. History tells us that those countries that sign onto security agreements with one another tend to hold each others’ currencies, notably the pre–WWI European Triple Alliance – Germany Austria-Hungary and Italy --and the Triple Entente – Britain, France and Russia.
We should remember that those who thrive are not the fittest, but the most adaptable. While many doubt that the US$ will be toppled from its perch, the disintegration of US institutions, the drift to isolation, autarky and a command economy free of the constraints of law have changed its place in the structure of international economy and financial system. There can be no going back for a generation.
The upshot: the US has imposed a structural break on the global trade and financial arrangement meaning that the relationships between economic and financial variables has changed. Structural change is abrupt, not gradual, and has destabilized the underlying model we use to assess the distribution of return and risk. This must invalidate prior decisions.
Other economies and sovereigns are already out of the gate, seeking to insulate themselves from harm. They are building new infrastructure – physical and administrative – to redirect trade away from the US. Many are also arranging to make payments in currencies other than the US$.
As capital flows change to reflect the new global trade realignment, so too will the relationships that underpin today’s foreign currency hedging decisions. An accompanying note next week will examine what this implies for strategic and tactical foreign exchange management.