The Dollar Milkshake Theory – Stress Testing the Potential Impact of a Sovereign Debt and Currency Crisis
Stress Tests play an important role in improving financial stability by enhancing market discipline and transparency. Here we consider the third example of these stresses based on current market conditions and show how the risk factors can be generated along with their relevant shock examples.
Dollar Milkshake Theory
The Dollar Milkshake Theory, developed by Brent Johnson of Santiago Capital, focuses on a potential Sovereign Debt and Currency Crisis centred around the US Dollar. While the availability of dollars, cost of dollars and level of the dollar have a huge impact globally, the most important element is the rate of change of the dollar. Robert Triffin believed the US Dollar could not survive as the world’s reserve currency without requiring the United States to run ever growing deficits.
On the supply side, aside from the liquidity effects of the EuroDollar system, the US has been printing a lot of dollars since the financial crisis of 2008. As a result, you would expect the currency to fall. However, the dollar index is a relative index not an indicator of strength. It is true the US has indeed printed vast sums of its currency, however they are not alone and when comparing the global assets of central banks, the BOJ and ECB far outrun these (see figure below).
The demand however is the hidden difference. Everyone needs dollars as everything is priced in it – be it the copper that China buys from Australia or oil that Europe buys from the middle east – as are the trade invoices, currency reserves and dollar denominated debt, with the latter being the most important.
With global debt to GDP estimated to be tipping 400%, as funding costs rise, there is pressure on local economies, leading to a credit contraction and a tightening of global supply. Supply does not seem to be enough to keep up and that appears to be why the US has escaped any inflation since 2008 before the supply chain crisis brought on by COVID. However, when other economies start to slow down and the US grows there are fewer dollars in global circulation, with the result that prices then go up as other countries, who are already suffering, still need to pay in dollars.
And so starts a dangerous vortex – as the dollar rises the rest of the world needs to print more and more of its own currency to convert to dollars to pay for goods and to service its dollar denominated debt. As a result, many countries will be forced to devalue their currencies and the dollar continues to rise. This could potentially lead to a Sovereign Bond and Currency Crisis.
So, what are the alternatives? The Yuan, Yen, Euro? China is currently struggling with the deflationary pressures of a falling real estate market. As a country that imports a lot, this can lead to inflation, and with goods priced higher, they are now feeling the squeeze. To combat this, they may be inclined to ease monetary policies and reduce deflationary pressures. Alongside this, with the Yen depreciating in value the regional offering from Japan’s exports can become more competitive. China may devalue the Yuan, which could cause a deflationary wave out of China, leading to an even higher dollar and potentially result in its runaway ascent. And if the dollar gets too strong? Well, we’ll see an occurrence that some may refer to as the End Game, or a Great Reset, or perhaps even a Fourth Turning event.
Our most recent interns, Nicholas and Timur, both joined us from Imperial College London where they are going into the third year of their Mechanical and Aerospace Engineering degrees, respectively. They spent 11 weeks working with TS Imagine’s Professional Services team in London this summer under the supervision of myself and Simarjit Johal (Regional Team Lead).
Since the start of the war in Ukraine, Western nations have imposed sanctions on many Russian individuals, businesses and state-run enterprises. Stress Tests play an important role in improving financial stability by enhancing market discipline and transparency.
Stress Tests play an important role in improving financial stability by enhancing market discipline and transparency. Clients leverage TS Imagine’s flexible and powerful risk engine to stress test a variety of specific scenarios. With Americans set to commence voting early next week, markets around the globe are watching carefully. Will the midterms disrupt the Democratic legislative agenda or tip in their favor? We ran two scenarios through our stress-testing engine, gaming the potential market impacts. Please note that these are hypothetical shocks and are not a prediction of any forthcoming events.