In my last article, I contrasted international investing under the British Empire to global macro investing today. In this article, I’ll delve deeper into the topic.
A global macro investor needs to have an understanding of all asset classes across all markets. Unlike a typical value investor, he does not just buy and hold a stock of a good company with solid fundamentals. He has to observe the world, predict a trend, and develop trading ideas to benefit from that trend. He also has to size his positions (more on that later) to keep his portfolio aligned with his investment objectives.
As we start on this journey, we need to learn:
Currencies
Commodities
Bonds
Equities
Real Estate
The focus of this article will be currencies.
The King of all Currencies
The world’s top currency is the United States Dollar. $50 and $100 bills are recognized by people all over the world. As Jim Rogers observed on his around the world trip, every country has a black market where the local currency is exchanged for the US dollar (mostly at a premium to the official exchange rate). People in Latin America, Africa and parts of Asia prefer to have their savings in the US Dollar rather than in their local currencies, which they mistrust. King Dollar rules the world, and quite rightly so.
The dollar is regarded as the world’s reserve currency because the US is regarded as the world’s dominant Empire. Historically, the currency of the dominant Empire has always gained reserve status. However, the US dollar is unique in that it has value in and of itself. It is not tied to anything of tangible value.
The British pound, for much of its history, was freely convertible into one pound of sterling silver (hence the original name – the pound sterling). Bank notes were redeemable at the issuing bank for gold or silver. The French franc and the Dutch guilder were just fancy names given to gold coins used as currency in France and the Netherlands. They were all universally (at least within their Empire) accepted as money, but they had no more value than the amount of gold or silver, in weight, that they represented. So, in a sense, the ultimate currency in this era of world history was gold, silver or both.
All that changed when the US dollar took over the baton from the British pound. The US dollar, in 1921, was freely convertible into gold at the rate of $20.67 per troy ounce. This convertibility would last only until April 5, 1933.
The dollar lost all domestic convertibility at that point, and citizens were forced to turn in their gold for paper dollars. On the international stage, the dollar was valued at $35/troy ounce of gold – a 70% devaluation over its previous official value. The dollar then continued as a world reserve currency at this valuation until the end of World War II.
The Bretton Woods System
The US dollar got a boost at the end of WW II because the US was the only country not devastated by the war. It was adopted as the official reserve currency by the central banks. The central banks could hold their reserves in gold and dollars, and redeem their own currencies in dollars. The central banks would also have the ability to present dollars to the US for redemption in gold. The exchange rates for all currencies against the dollar was fixed, and the price of dollars was fixed at $35/gold oz. This was an arrangement made by the central banks, for the central banks. A French citizen could not walk into the Federal Reserve building and demand gold for his dollars, but the Bank of France could.
The Collapse
The system collapsed because the US printed so many dollars that other countries became nervous and tried to exchange their dollars for gold. This resulted in a run on US gold reserves, and in an attempt to hold on to their gold reserves, the US reneged on its promises under the Bretton Woods agreement and suspended redemptions. On August 15, 1971, US President Richard Nixon won freedom for the US dollar.
Floating Exchange Rates
Since that time, all currencies have been priced by the market based on demand and supply, rather than on how much gold/silver they represented. The US dollar went through a crisis, but continued as the reserve currency once Saudi Arabia agreed to accept dollars in payment of oil. Since Saudi Arabia was the world’s largest oil producer, oil was de facto priced in dollars. Any country wishing to buy oil had to hold dollar reserves. The world needed oil, the world needed dollars, and the dollar was once again King.
The severance of the currencies’ last link to gold did not come without consequences. The US dollar rapidly depreciated in value throughout the 1970s, and in 1978 the mighty US government was forced to issue bonds denominated in German Marks and Swiss Francs (seen as the epitome of strong currencies) to prevent the fall of the US dollar on the international stage.
Resolved to stabilize the dollar, the Federal Reserve (the US central bank) kept raising interest rates. This brought inflation under control, expanded the pool of savings, and after a sharp recession, the dollar was stable and the economy was booming. Trust in King Dollar had returned, and the dollar had a good quarter century run.
Until 2008.