The Rising Dollar and Bitcoin

Bitcoin as Portfolio Insurance?

The global shutdown and ensuing policy assistance in response to the pandemic contributed to inflation rates that we haven’t seen in almost 50 years in most major economies. These elevated levels of inflation led to a shift in policy beginning at the start of 2022 that has driven central banks to revert from their long run of lowering interest rates and balance sheet expansion to raising interest rates and attempting to shrink balance sheets. This reversal has led to the strengthening of the dollar compared to other major currencies, with the dollar index rising approximately 17% year-to-date, according to Bloomberg.¹

Recent weeks have shown just how reliant the financial system is on the U.S. dollar and the economic damage that can take place with its rise. Some central banks have already been forced to reverse course from their recently initiated tightening measures, including the move by the Bank of England to buy bonds rather than sell them as planned. In this piece, we offer an overview of the structure of the existing global monetary system and perspective on how the past several weeks may have driven us closer to an era in which more people start to consider bitcoin as insurance, or a hedge, on the existing monetary system.

Central Policy Responses

The level of response associated with various financial crises from monetary and fiscal policymakers globally, and particularly in the United States, has increased over time. The global financial system now exhibits more leverage, and arguably more reliance on central policymakers, than ever before. The Alan Greenspan era kicked off an ever-increasing level of monetary policy intervention in the United States and resulted in the creation of the term “the Greenspan put.” Over time, events such as the 1987 flash crash, the popping of the 2000 technology bubble, the 2008 housing and banking crisis, and the recent pandemic, have driven monetary and fiscal policy responses that have grown in magnitude with each subsequent event.

Ultimately,  policy intervention cannot come without some form of consequence or an offsetting tradeoff. This tradeoff can be seen in the ballooning of sovereign balance sheets worldwide. The United States’ debt to GDP ratio is currently north of 120%, rivaled in U.S. history only by that of the post-World War II era, which was followed by a period of negative real interest rates and dollar debasement. The most recent sustained period of rising rates and monetary tightening occurred under U.S. Federal Reserve Chair Paul Volker in the late 1970s, but at that time, U.S. debt to GDP ratio was only around 30% — a much lower debt level  that the government could handle compared to today. 

Data Source: Federal Reserve Economic Data as of 09/30/2022. 

The Dollar Milkshake & Recent Currency Movements

Additional complications enter the fold when considering the global and interwoven nature of currencies and debt obligations. The “Dollar Milkshake” theory, coined by Brent Johnson of Santiago Capital, hypothesizes that periods of tightening financial conditions are exacerbated by the world’s heavy reliance on U.S. dollars. The reference to milkshakes comes from the virtual image of the U.S. dollar sucking up liquidity from other currencies during times of crisis. This can be seen in a recent New York Fed report stating:

“In private transactions, although the United States only makes up a quarter of global GDP and just over 16 percent of world exports and imports, the U.S. dollar continues to be represented at a disproportionately higher rate in financial transactions. Approximately half of all cross-border loans, international debt securities, and trade invoices are denominated in U.S. dollars… Global banks’ U.S. dollar-denominated liabilities have been steadily increasing since the GFC [Global Financial Crisis of 2008] and are the highest among major international currencies, with a balance of over $15 trillion in 2021."²

The disproportionate amount of debt denominated in U.S. dollars is very likely a leading factor that can explain why the U.S. dollar rises so sharply during periods of widespread deleveraging, as this effectively creates a short squeeze on the U.S. dollar at the expense of these nations’ local currencies.

Recent weeks point to the potential validity of this theory as the Federal Reserve’s year-to-date tightening cycle appears to have weighed heavily on other major currencies. The Dollar Index is now at its highest level since 2002.

Data Source:  Bloomberg as of 09/30/2022.

The previous historic dollar-spike to all-time highs, seen in the chart above, drove the Plaza Accord in 1985, a coordination amongst G-5 nations (France, Germany, United Kingdom, United States, and Japan) aimed at weakening the U.S. dollar and helping to rejuvenate the U.S. manufacturing industry during a period of large U.S. trade deficits. The agreement did achieve its objective of dramatically weakening the U.S. dollar, while also potentially contributing to the boom and bust of the Japanese economy of the late 80s into the 90s.

Despite the Dollar Index currently remaining quite far from these historic levels seen only in the 1980s, today’s leverage and reliance on U.S. dollars across the globe has the potential to create a similar, or even more extreme, event that could require global coordination to reduce the elevated strength of the world’s most prominent fiat currency. As the Federal Reserve continues to tighten in the United States, some governments have already started easing, which could drive the dollar even higher against non-USD currencies.³

Focus on Sovereign Debt

This past month also saw a renewed interest in country sovereign debt levels as the United Kingdom announced a new fiscal package that included large tax cuts. The package would be approximately 1.4% of U.K. GDP, much larger than expected, putting into question how high of a deficit the U.K. government budget and bond market could handle. The British Pound sold off on the announcement, hitting a low of 1.07 versus the U.S. dollar, the lowest level since the end of 1984 when the pound hit approximately 1.15, according to Bloomberg data, which then was reversed with the Plaza Accord.

U.K. bonds also sold off, with the 10-year yield hitting 4.5%. The sell-off caused widespread volatility and some panic among investment banks and pension plan investors due to reported widespread margin calls.⁴ The Bank of England then intervened in the market, buying billions of dollars of long-term bonds and pledging to do more as necessary. However, the bond-buying program is set to end in mid-October⁵(as of this writing), so it remains to be seen what the market will do without the support or if more intervention will be necessary.

While the U.S. dollar remains very strong relative to other fiat currencies, the reality of the U.S. financial system is that it is in a similar position as the U.K. in the long run. As noted, with the high debt-to-GDP ratio it is unlikely to be equipped to handle higher real interest rates for a sustained period of time if the country aims to fulfill its current debt obligations. Total U.S. debt is now over $30 trillion according to the U.S. Treasury, which does not count the more than $170 trillion in unfunded liabilities. With the Federal Reserve increasing interest rates and a relatively low average duration on the U.S. debt, interest payments have risen to an annual rate of approximately $650 billion, as of Q2 2022. Annual interest expense has already exceeded the annual cost of Medicaid and may soon exceed the current cost of Medicare ($689 billion in 2021) or even the entire U.S. defense budget ($742 billion in 2021) as interest rates continue to rise along with the overall debt level.

Bitcoin as Potential Insurance

Now, what does all of this have to do with bitcoin?

Recall that bitcoin was created amidst the 2008 financial crisis as a non-sovereign asset that individuals can peacefully opt into with a portion of their capital. Its supply schedule is entirely predetermined and it continues to execute its code exactly as its rules outline. According to the current code, there will only ever be 21 million bitcoin and the current inflation rate of approximately 1.7% is set to continue to decline, regardless of any macroeconomic factors. 

Therefore, bitcoin may soon stand in stark contrast to the path that the rest of the world and fiat currencies may take – namely the path of increased supply, additional currency creation, and central bank balance sheet expansion. The United Kingdom is the latest example of the current predicament world governments and central banks find themselves in; wanting to revive faltering economies and struggling economic growth with fiscal tools, with a central bank that is tightening to try to fight decades-high inflation, but then encountering market stress that requires more liquidity to tamp down financial volatility and keep it from spreading. Some U.K. investors or traders may have already noticed bitcoin’s potential to opt out of the current situation as trading volumes between the British pound and bitcoin spiked to a record high.⁶

To summarize, the strengthening U.S. dollar is wreaking havoc among other countries and may put pressure on the Federal Reserve to soon reverse its tightening monetary actions, something that has precedent based on 1985’s Plaza Accord. Additionally, more monetary debasement may be needed to alleviate the high debt load among developed economies, while recent events in the United Kingdom have shown counterparty and liability risks in the system, making monetary intervention and doses of liquidity features that are not likely to go away any time soon. Comparatively, bitcoin remains one of the few assets that does not correspond to another person’s liability, has no counterparty risk, and has a supply schedule that cannot be changed. Whether those properties begin to look more attractive is ultimately up to investors and the market to decide.

Contributors:

Edit: This article was updated on 10/24/2022 to clarify that $170 trillion referenced above was in unfunded liabilities.

Christopher Kuiper, CFA, Director of Research, Fidelity Digital Assets
Jack Neureuter, Research Analyst, Fidelity Digital Assets
Matthew Hogan, Research Analyst, Fidelity Digital Assets
Daniel Gray, Research Analyst, Fidelity Digital Assets