Don’t Be Misled By The Sweet Name, The Dollar Milkshake Is No Treat For Investors

Normally, we love a milkshake. But the “Dollar Milkshake Theory”, a market concept whipped up by Brent Johnson, CEO of Santiago Capital, is one nobody really wants. It means a massive squeeze higher for the US dollar, and a massive worry for investments all over the world. Here’s why, and how you can protect your portfolio from frosting over…

What is the Dollar Milkshake Theory?

The milkshake theory basically holds that there simply aren’t enough US dollars created to keep up with the rising demand. And when the greenback rises high enough, fast enough to lead to defaults abroad, the demand for dollars swirls up and its supply shrinks, leading to an epic squeeze higher. The result is a sovereign debt crisis, a massive devaluation in other currencies, and a likely big blow to your portfolio.

According to the theory, the whole financial world is a giant milkshake of liquidity and the US dollar is its main ingredient. And, of course it is: the whole world depends on US dollars. More than 80% of the world’s trade is done in dollars. Nearly 60% of the money held by the world’s central banks in their “reserves” is in dollars. And governments and corporations all around the world borrow funds – generally, by selling bonds – priced and paid in US dollars. (In fact, there’s more dollar-denominated debt created outside of the United States than inside). In other words, if there’s one thing that truly holds our whole financial system together, it’s the greenback.

And generally, this doesn’t work out badly. Take a foreign company or government with ambitious plans to grow or develop: if they know they’re going to see some revenues in US dollars, they’re more likely to finance their plans with a dollar-denominated loan. See, they know the debt will be easier to access and come with better terms than if they’d financed in their local currency. And, as long as they can make enough dollars to pay the interest on their loan, they can grow faster than they would have without borrowing. So most of the time, this access to US dollar liquidity is beneficial for global growth.

But trouble starts to brew when those foreign entities struggle to bring in enough dollars to pay the interest – maybe because of a shortage of US dollars, or from financial difficulties. A strong dollar, like we have now, exacerbates both of them.

What’s so bad about a strong dollar?

When the greenback rises, it can be a double whammy for foreign businesses and countries. First, the things they buy like food, energy, and raw materials – all typically priced in dollars – become more expensive. Second, it increases the cost of the money they owe in debt. If they’re paying 5% interest on their bonds and the dollar rises by 10%, the cost of paying back the debt jumps to 15%. This increases the risk of default, and will generally push creditors to demand higher interest rates. For a company, that could mean an end to expansion projects, or worse. For an economy, it could mean a downturn in growth and cause its currency to weaken even more versus the dollar.

Right now, demand for the dollar seems to only be getting stronger. Companies and governments need more of them than they did before, just to pay back the huge amount of debt they took when interest rates and the dollar were exceptionally low. And investors are keen to get their hands on them too, as recession fears grow and lead them to seek out safe assets.

And meanwhile, the supply of greenbacks may soon be reduced: if companies and governments default on their USD-priced debt, the dollars associated with them effectively disappear, shrinking the money supply. And since the Fed is no longer pouring liquidity into the markets with those low interest rates, the Dollar Milkshake Theory goes, it’ll instead be sucking the capital up through a straw.

How might this affect your portfolio?

First, you can expect an even stronger dollar if we see markets go full milkshake theory. And that means other currencies are likely to be sharply devalued. So any assets you own in other currencies (say, emerging markets stocks or European bonds) could lose a chunk of their value.

Second, you’d see a major sovereign debt crisis. If countries around the world become unable to repay their debt, there’d be a rapid and painful deleveraging episode, as governments seek to cut costs and raise money. Interest rates would likely rise, and the price of any sovereign bonds you hold would crumble.

Third, the global financial system would likely crash, bringing assets down with it. Aside from the US dollar, no asset is likely to be spared when that happens, not even real assets like commodities, alternative assets like private equity, or even cryptocurrencies like bitcoin.

The one possible exception might be US stocks, which could see an initial selloff but then recover. That’s because all the money that had been in debt markets will be looking for a new home, and US shares could emerge as the least bad option.

What’s the opportunity?

Now, before you sell everything and put all your savings in US dollar cash, it’s important that you remember what the theory is not saying.

First, it’s not saying that the greenback will avoid a temporary correction, or that it will go up forever. It’s not even saying that the dollar won’t someday be dethroned by some other currency (a digital one, maybe). But what it is saying is that there’s a strong chance that the greenback will see a disruptive blast higher over the next few months (or potentially even years).

Second, it doesn’t say that the US dollar won’t get “debased”, or knocked down in value. The theory says that the US dollar is likely to rise versus other countries’ fiat currencies, but doesn’t rule out the possibility that it might fall compared to non-fiat currencies. So there might still be a case for adding bitcoin (or even gold) to your portfolio.

Third, as Brent Johnson himself admits: there’s a decent chance he’s wrong and the calamitous milkshake scenario never materializes. Perhaps companies and countries will find a way to reduce all that debt without a disruptive hard landing. Perhaps the world’ll experience a smooth and efficient transition to some new reserve currency. Perhaps some other factors will stem the rise in the US dollar before too long.

One way or another, the greenback is having one rocketship of a year, blasting past every single major currency. And regardless of whether this full milkshake happens, the US dollar is still likely to be the one hedge that can protect your portfolio against the possibility of a simultaneous fall in assets.

To add a US dollar hedge to your portfolio, you could consider investing in a dollar-based ETF, such as the Invesco DB US Dollar Index Bullish Fund (ticker: UUP, expense ratio: 0.78%).