The US dollar started the year 2015 on a very strong note, rising on the first day of trading by 0.8% against the basket of 16 other currencies that makes up the Wall Street Journal Dollar Index. That gain came after a 14% rally in 2014 that carried the greenback to its highest level against major currencies since September 2003 and to a peak vis-a-vis emerging market units not seen in some 14 years. Indications are that the USD’s high-flying act is not even close to coming to an end just yet. It will have its occasional setbacks in the weeks and months ahead, but the underlying trajectory will stay pointed upward.
At this time, none of these ill tidings show an inclination to take a turn for the better. Without exception, they appear set to get worse. This creates uncertainties that are making investors nervous. The US dollar then tends to shine as one of the safest currencies to hold. It is, and will remain, the currency with the deepest and best-regulated financial markets, where investors can shift assets with ease and speed. It is also the globe’s preeminent unit for trade and storage of value, a position in which it is not seriously threatened by any other currency.
A second key reason for the positive outlook for the dollar is that, in a world in which everything is relative, the US economy is doing quite well, certainly better than those of most other industrial nations. While the euro was given a potent shot in the arm when Mario Draghi, the president of the European Central Bank, last year vowed to do “whatever it takes” to support the common currency, member states of the Eurozone have had plenty of disappointing news to digest since then.
A number of member countries are in – or on the brink of sliding into – recession. Even Germany is not doing nearly as well as many had anticipated at this time in 2014. Japan is struggling to avoid deflation. Every fresh set of official statistics out of China confirms that the PRC’s economy is slowing markedly. Against this backdrop, the US Federal Reserve has ended its “quantitative easing” program and is widely expected to announce, sometime later this year, the first interest rate increase in almost a decade from near zero, amid steady improvement in the US labor market.
In fact, the Fed is poised to tighten credit just as other Central Banks, such as the ECB and the Bank of Japan, are weighing expansions of their easy-money policies. This raises the likelihood of a mass-reversal of carry trades, which reflect a strategy that has investors borrowing in a low-interest currency, such as the US dollar, and then invest the proceeds in a higher-yielding one, often in emerging markets. Such positions come under stress when the monetary unit in which funds were borrowed starts rising strongly against that in which they were invested.
With dollar interest rates and the greenback itself on an upward trend, one has to wonder when investors will decide that their risks of exchange market losses are greater than the advantage they gain from the interest rate differential. Once they start unwinding their carries en masse, selling emerging market assets to purchase dollars, they worsen the interest and exchange rate constellation from which they are trying to escape. No one seems to know exactly how much money is involved in these carry trades, but the share of government bonds owned by foreigners is said to be over 35% in, for instance, Malaysia, Poland, Hungary, Mexico and Indonesia. Regardless of the actual magnitudes, any reversal of carry flows will boost the US dollar. So, intermittent setbacks notwithstanding, on balance there is no way for the dollar to go but up.
This has its advantages. It puts extra downward pressure on international oil prices, which leave more cash in the wallets of consumers. It makes it cheaper for Americans to travel abroad. More importantly, it fuels, at least in the short run, US stock and bond markets by boosting the returns for global investors, who measure their performance in other currencies. In the medium- to longer term, however, a persistence of the greenback’s irresistible strength will have more negative than positive consequences.
While a depreciating currency can be a boon for some countries, making their exports more competitive, it also makes imports more expensive, driving up inflation. Companies in emerging markets already face substantially higher costs on roughly USD 1 trillion in dollar-denominated bonds sold to investors to take advantage of low US interest rates, before the greenback’s surge began. It now costs borrowers more to make regular payments on these securities and to pay off outstanding paper as it matures.
Bond markets in emerging-market countries recently suffered one of their worst selloffs since the global financial crisis of 2008, based on a Barclays PLC index of emerging market debt in dollars. The debt burdens in these nations will intensify as the USD keeps rising and squeezes with growing intensity enterprises earning much of their income in Indonesian rupiahs, Chilean pesos, Brazilian reais or Turkish liras, all of which are near multi-year lows, or Mexican pesos, on whose behalf Banco Central intervened last month to moderate the slide.
In the United States, the stronger dollar hurts exporters by raising their production costs compared to those of their rivals. It makes imports more attractive for consumers. It also damages the bottom lines of companies operating abroad by shrinking non-US profits when these are converted into dollars. The main question, of course, is how much higher the greenback will soar. But for now, fundamental, technical and flow & momentum indicators all support a further rise, possibly a rather substantial one.
There are a number of reasons for this. One rests in the geopolitical risks that threaten people and business around the globe, from the brutal fighting between opposing militias in Libya, the seemingly never-ending confrontation between Israel and the Palestinians and the by now almost certainty of Iran emerging as a nuclear power with all the regional and world-wide consequences, to the barbaric and spreading Islamic State run by ISIL in Syria and Iraq, the aggression displayed by Russia in Ukraine and the growing assertiveness of Beijing in the East and South China Seas.
[March 6, 2015]