WHAT IS THE DOLLAR MILKSHAKE THEORY?

Despite Ray Dalio’s opinions on the dollar, others are not sure this will play out. One of them is Brent Johnson, who first introduced the Dollar Milkshake Theory and pushes back on the thought that the U.S. has reached its zenith as a world superpower. 

You may have seen the U.S. dollar (USD) reach a 20-year high in 2022, according to the DXY Index, so the dollar’s current strength is not in question.

Brent Johnson argues that, at some point, debt is going to matter. Central banks have done a remarkable job of kicking the can down the road via quantitative easing, bailouts, PPP loans, and stimulus checks, but eventually, you have to pay the piper. 

Nearly every central bank has followed the same playbook and flooded its economies with liquidity. Meaning the currency debasement that’s impacted the dollar is nothing unique. 

To that point, inflation has been a global phenomenon this past year or so, not just an American one.

WHAT YOU NEED TO KNOW ABOUT THE DOLLAR MILKSHAKE THEORY

The Dollar Milkshake Theory says that the global central banks created a big “milkshake” of liquidity with their unprecedented monetary easing, which injected roughly $30 trillion of reserves into the economy since 2008.

When the Fed’s policy transitioned from easing to tightening, with interest rates increasing, they’re exchanging a metaphoric syringe for a big straw sucking up liquidity from global markets. As liquidity gets sucked up, the dollar strengthens against other currencies, putting immense pressure on countries with dollar-denominated debt. (Put simply, it just got a lot more expensive for those countries to repay their debt.)

This creates a dangerous feedback loop. As more capital flocks into U.S. assets, supporting demand for the dollar, debts denominated in dollars globally become more expensive as countries’ local currency loses value against the dollar. 

As America sucks up financial flows globally, companies and governments outside the U.S. see their credit risks increase due to their diminishing ability to pay down foreign debts denominated in dollars, amplifying investors’ fears and compelling more capital to flee.

WHY DOES THE DOLLAR STRENGTHEN?

Safe haven

The dollar strengthens in this scenario because the U.S. offers a financial safe haven with its liquid markets, established financial system, strong rule of law, etc., where large institutions and investors can feel comfortable storing their money, as well as higher interest rates on its government debts.

According to the New York Fed, “Approximately half of all cross-border loans, international debt securities, and trade invoices are denominated in U.S. dollars…and 60 percent of global foreign exchange reserves are in dollars.” 

They conclude that rising U.S. public debt levels and inflation could become more concerning to foreign investors. However, no currency replicates the characteristics of the U.S. dollar as a store of value, unit of account, and medium of exchange. Moreover, U.S. assets are viewed to be safe and liquid and have withstood the effects of global shocks.

Interest rates

The reason higher interest rates on U.S. government debts comparatively support the dollar has to do with what’s known as a ‘carry trade.’

For example, some central banks, including Japan and the ECB (European Central Bank), still have comparatively ‘easy money’ policies and have kept rates closer to zero. Investors seeking higher yields dumped Japanese and European bonds with barely positive yields for higher-yielding U.S. Treasuries that have.

In their eyes, government bonds from these countries all carry roughly the same level of risk, yet they can earn more interest by parking their money in the U.S. 

As a bonus, it’s not unreasonable to think that U.S. government debt is even safer than that of Japan and Europe, since the U.S. could theoretically just print dollars to pay down its debt obligations in an emergency. For Japan and Europe, like most countries globally, a large swathe of their debt is denominated in dollars, which they cannot print in a crisis. 

In other words, U.S. Treasury bonds offer better returns with less risk, which is why the carry trade is tempting. 

This yield differential on ‘risk-free’ government bonds is corrected, in part, by currency repricing. In this instance, it results in the U.S. dollar outperforming other currencies.

CARRY TRADE: HOW IT WORKS

In a carry trade, an investor might borrow in a currency with a lower interest cost and then invest those borrowed funds in a country where they can earn a higher yield above their borrowing and currency hedging costs. 

This was the story of 2022, as traders and investors exploited the higher interest rates in the U.S. compared to much of the rest of the world.

If the spread in sovereign bond yields is large enough, it incentivizes investors to execute this trade en masse which ends up boosting demand for U.S. dollars (to purchase government bonds) until the spread narrows to more appropriate levels.

To do that, you would sell your borrowed yen or euro and buy USD, putting further downward pressure on the yen and euro while demand for USD pushes up its exchange price level.

HOW THE DOLLAR MILKSHAKE THEORY HAPPENS

Despite efforts by Russia and China, the bulk of global trade is still settled in USD. Additionally, the entire investment world depends upon the dollar, and its money flows, as global loans made in USD need to be paid back with interest in USD. The Dollar Milkshake Theory explains a USD rally in terms of basic market dynamics of demand for dollars exceeding their supply.

The world is currently awash in dollar-denominated corporate and sovereign debt, and the repercussions of this massive leverage may eventually be a burden too heavy to bear. It may kick off a sovereign debt crisis if the loans can’t be repaid.

In the meantime, however, it creates a massive demand for dollars for both trade and debt repayment. As mentioned, this will lead to the US dollar strengthening and siphoning off the liquidity of currency markets worldwide, according to Brent Johnson.

In a sovereign debt crisis, Brent Johnson expects the dollar’s value to rise dramatically against all other assets and suck up the liquidity of foreign currencies. As the dollar rises, global capital will flow into the United States. American markets would have plenty of liquidity then, but markets globally could see a severe credit contraction.

This also happens because the U.S. financial system has an unparalleled and unrivaled recent history of deep liquidity and stability. No other country has sufficiently robust capital markets to anchor the global economy. In a panic, investors flee less established financial systems, weaker currencies, unstable government regimes, and more volatile economies for the safety that the dollar represents and the institutions that underpin it.

THE DOLLAR MILKSHAKE THEORY EXPLAINED AND SUMMARIZED

Ultimately, vulnerable countries in a crisis must either print more of their own currency to obtain dollars (which can make things worse if they print too much and faith in their currency is lost) or dramatically cut spending, which could provoke social tensions as people see their benefits slashed. 

Otherwise, they risk default unless they can secure a bailout from another country or entity like the International Monetary Fund. In a global crisis like the one envisioned by the Dollar Milkshake Theory, bailouts would be unlikely, given the scale of the issue.

In the aftermath of a Dollar Milkshake-style financial crisis, more countries may adopt the US dollar as their base currency to promote stability and restore faith in their government. 

This is actually more common than you might think: 65 countries globally have their currencies pegged to the U.S. dollar. This may be either in having the U.S. dollar as their official currency, such as in El Salvador or Zimbabwe, or in pegging their own currency’s value to the dollar, like in Hong Kong and Saudi Arabia.

As this happens, the dollar and dollar-denominated assets become even more systemically important.

In other words, a debt crisis or other systemic financial contagion could spawn a currency crisis that results in the U.S. dollar further entrenching itself as the world’s reserve currency. At least, that’s one plausible outcome, according to Brent Johnson.

The root cause is excessive household, corporate, and government debts. While the U.S. dollar can still lose its purchasing power against goods and services (price inflation), its value relative to other currencies is essentially the world’s gold standard, especially in a crisis.

The Dollar Milkshake Theory captures this outlook and hypothesizes that global chaos cements the dollar’s role and value further rather than precipitating its downfall.

A dollar collapse would be shocking, which makes it interesting to speculate about. The fact that it feels so shocking, though, is perhaps evidence of just how deeply ingrained the dollar system is.

FREQUENTLY ASKED QUESTIONS ABOUT THE DOLLAR MILKSHAKE THEORY