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The possibility of the U.S. dollar losing its role as the world’s reserve currency is deservedly getting a lot of attention of late. Investors should take heed.

This anxiety has been caused by the cultural and economic challenges the United States seems to be facing. China, Russia, India, and Brazil are actively looking to lessen the dominance of the greenback in international finance. This group of four countries has a population of 3.2 billion people – 40 per cent of the world’s population – and a combined gross domestic product of approximately US$24-trillion. This combined GDP is roughly the same as that of the U.S. and is greater than the European Union GDP of US$16.6-trillion.

The U.S. dollar’s weakening position in global capital markets is the country’s own doing.

It is because of decades of fiscal irresponsibility and anemic economic growth which was veiled by artificially low interest rates and the fact that the country controlling the world’s reserve currency and primary medium of international exchange lowered the cost of borrowing. Furthermore, the U.S. administration has chosen to weaponize the dollar, most recently by kicking Russia out of the international payments system and by confiscating its assets.

China, India and other countries have understandably become concerned that one day they too could draw the ire of an increasingly petulant U.S.

Trust in the U.S. and its currency has not been lost but it has been severely degraded over time as the country’s debt levels have skyrocketed and its interest rates sank through quantitative easing policies. History teaches us that even great empires have a credit limit regardless of their ability to print their own currency. We can look to the British Empire, Mongols, Ming Dynasty, the Romans and countless other victims of the hubris of currency debasement.

That said, the U.S. dollar will remain a reserve currency for some time. Its decline has been and will continue to be gradual.

This can be seen in two key metrics.

As a percentage of foreign reserves, the U.S. dollar’s market share has fallen from more than 70 per cent 25 years ago to less than 60 per cent. It remains dominant and the decline is in the context of a growing world economy. However, we seem to be entering a new epoch where the rest of the world, with the exception of U.S. satellites such as Canada, are actively looking to move away from dollar-dependency, as the U.S. administration increasingly uses its reserve currency status as a weapon to achieve its political goals.

The other metric demonstrating the longer-term decline of the dollar is the fact that for years now, U.S. Treasuries have traded at higher yields and lower prices than the bonds of developed countries such as Germany, independent of their relative inflationary and fiscal realities. Typically, the debt of reserve currency countries enjoy high demand relative to their economic outlook and can issue debt at lower levels, all things being equal. This is no longer true for the U.S.

U.S. bond yields dropped below those of Britain around the time of the First World War and stayed lower. This was not totally coincidental with the U.S. usurping that country’s role as the world’s most powerful economy and after the Second World War, the dominant military empire. Britain had been exhausted by costly foreign wars.

Fast forward to today and the similarities are impossible to ignore. The U.S. has seen its financial position gradually erode after paying for numerous direct and proxy wars from the Korean Peninsula, to Southeast Asia, to the Middle East to Ukraine.

The U.S. dollar index, a measure of the value of the U.S. dollar relative to a basket of foreign currencies, has dropped by about 11 per cent since late September, 2022. The Canadian dollar, in turn, has lost about 9 per cent of its value against the U.S. dollar and 13 per cent against the euro since the middle of 2022.

Markets, especially currency markets, never go in a straight line forever. There will eventually be a counterrally. However, investors need to appreciate that we are in a period of change. The U.S. is losing political and economic respect among its friends and allies. And the first lesson taught in international business in university is that investors demand compensation for political risk.

The old Soviet Union was a closed economy and was never of much international economic importance although it was a military force to be reckoned with. From 1945, we have been in a unipolar world with the U.S. dominant with its currency and the ability to ensure trade flows as a strong naval power. We are now, albeit gradually, shifting to a multipolar world. The interests of Europe, especially, are losing alignment with those of the U.S.

Canadian investors need to understand that the relative position of the U.S. is changing – and that will affect Canada by default as well.

Do not assume that if the U.S. dollar runs into chronic problems that the loonie will magically rally to par. When the U.S. catches a cold, Canada catches pneumonia. We are dependent on the U.S. economy and will continue to be despite what politicians and pundits will tell us.

On top of this, Canada has its own fiscal, economic and political problems.

Investors should look offshore to diversify their investment opportunities. Equities in other countries can sometimes offer more attractive opportunities than in North America, relative to risks.

In addition, investors may want to take a long-term and prudent approach and move some bond exposure out of Canada and the U.S. to diversify.

Income is still attractive. German bond yields, for instance, trade only 50 basis points below Canada’s. Many other developed countries trade at yields more generous than German bonds.

There are plenty of international bond ETFs of developed and less developed countries, as well as those in sovereign and corporate debt and in many combinations.

The world is changing and so should investor attitudes.

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