Cathay Haitong: Beware of US dollar credit downgrade and energy shocks, but technological advances leave room for a soft landing

Zhitong Finance APP learned that Guotai Haitong issued a research report stating that in the 1970s, the U.S. dollar delinked from gold, which led to a global downgrade in trust in the fiat money system. Afterwards, it also coincided with the shock of the energy crisis, significantly increasing volatility in the prices of major asset classes. With the current reshaping of the globalization order, the dollar’s credit—benefiting from globalization—is again facing challenges, and recent global energy shocks are also intensifying.

The current U.S. similarity to the 1970s lies in the combination of a “downgrade in fiat money credit” and an energy shock: the share of dollar reserves has fallen; conflicts in the Middle East have pushed up oil prices; and along with excessive money issuance and fiscal expansion, inflation faces a risk of losing its anchor. But the key differences are: the AI revolution has improved total factor productivity; shale oil has turned the United States into an exporter; and the weakness of union coverage and wage indexing provisions reduces the rigidity of the “wage—price spiral far below that of the time. The lesson from Volcker is that policy must demonstrate resolve to rebuild credibility, but current technological progress creates room for a soft landing. The Federal Reserve does not need to copy shock-therapy measures; if U.S. dollar credit continues to deteriorate and inflation loses its anchor, some of the 1970s experience is worth referencing.

The main viewpoints of Guotai Haitong are as follows:

In the 1970s, the U.S. dollar delinked from gold, bringing about a global downgrade in trust in the fiat money system. Afterwards, it also coincided with the shock of the energy crisis, and volatility in the prices of major asset classes clearly increased. With the current reshaping of the globalization order, the dollar’s credit—benefiting from globalization—is again facing challenges, and recent global energy shocks are also intensifying. We need to draw lessons and takeaways from the history of the 1970s.

Gold-linked: the establishment of dollar hegemony and the crisis. The Bretton Woods system established the dollar’s leading role as an international reserve currency through the “double peg” principle, but it faced the “Triffin dilemma.” After World War II, as Western Europe and Japan’s economies recovered, U.S. gold reserves continued to flow out. In the mid-to-late 1960s, the Vietnam War and the “Great Society” programs led to a rise in U.S. fiscal deficits, as well as excessive money issuance, ultimately making the Bretton Woods system unsustainable. In terms of asset performance, from 1945 to the mid-1960s, dollar-denominated assets saw stocks outperforming and strong bonds and exchange rates holding up; in the late 1960s, inflation heated up and the Federal Reserve tightened policy, real yields on U.S. Treasuries turned negative, and U.S. equities weakened amid volatility, increasing pressure for the dollar to depreciate.

Oil-linked: the reshaping of dollar hegemony and stagflation. After the breakdown of the Bretton Woods system, the United States reshaped dollar hegemony by binding the dollar to oil transactions through “petrodollar” agreements with countries such as Saudi Arabia. Oil-producing countries gained dollar surpluses by selling oil, which then flowed back to buy U.S. assets, providing the United States with low-cost financing. However, the two oil crises in the 1970s triggered a surge in oil prices, and combined with prior excessive money issuance, it pushed the U.S. into severe stagflation. In terms of asset performance, gold surged significantly after being freed from the official price constraints; prices of commodities such as oil and agricultural products broadly rose. The bond market entered a bear market, with the yield curve inverting multiple times. U.S. equities overall were weak, experiencing a prolonged de-rating; only the energy and raw materials sectors relatively held up against declines.

Volcker’s fight against inflation: defending a strong dollar. Faced with runaway inflation, after Volcker took charge of the Federal Reserve in 1979, he implemented aggressive tightening policies. By tightly controlling the money supply and raising interest rates to historical highs, he was willing to pay the price of a short-term recession to break inflation expectations, rebuilding the Federal Reserve’s credibility and the dollar’s strong position. In terms of asset performance, in the early stage of tightening, the bond market fell sharply and the yield curve inverted; the dollar strengthened as capital was attracted by high interest rates. The stock market turned from weak to strong: high interest rates suppressed valuations and earnings, putting pressure on the market; after inflation cooled and interest rates fell, earnings recovery and valuation expansion synchronized, and the U.S. stock market entered a long bull run. Commodities and gold fell sharply due to higher holding costs and a stronger dollar. Ultimately, the bond market ushered in decades-long bull markets, and the strong dollar position was consolidated.

Current U.S. stagflation expectations: similarities and differences with the 1970s. The similarity between the current U.S. and the 1970s lies in “a downgrade in fiat money credit” combined with an energy shock: the share of dollar reserves has fallen; conflicts in the Middle East have pushed up oil prices; and along with excessive money issuance and fiscal expansion, inflation faces a risk of losing its anchor. But the key differences are: the AI revolution has improved total factor productivity; shale oil has turned the United States into an exporter; and weakened union coverage and wage indexing provisions reduce the rigidity of the “wage—price spiral far below that of the time. The lesson from Volcker is that policy must demonstrate resolve to rebuild credibility, but current technological progress creates room for a soft landing. The Federal Reserve does not need to copy shock-therapy measures; if U.S. dollar credit continues to deteriorate and inflation loses its anchor, some of the 1970s experience is worth referencing.

Risk warnings: Escalation of geopolitical conflicts, increasing risks of global stagflation, and tighter monetary policy than expected, among others.