Tuesday, February 03, 2015

The USD Bull in the Global China Shop

The long-term consequences of primary FX trends may be entirely unintended.

Indulge me two "I told you so's":

1. That the U.S. dollar (USD) would rise a lot, confounding those busily digging the dollar's grave

2. That the stronger dollar would crush U.S. corporate profits earned overseas, negatively impacting U.S. stock valuations and markets.
My call for a significantly stronger USD goes back four years:

Could the U.S. Dollar Rise 50%? (January 12, 2011)

My call for the stronger dollar impacting corporate profits also goes back four years:

There may be plenty of other people who made the same calls as early and as consistently as I have, but I haven't run across their archives.

More important than the call itself is explaining the causal dynamics that made the stronger dollar inevitable. That's where the rubber meets the road: why will this happen? If we get that right, the call will be right.

More recently, I've discussed the consequences of a stronger dollar globally:

In effect, the failure to address the structural problems that caused the Global Financial Meltdown of 2008-2009 have been transferred to the larger foreign-exchange (FX) market, which is connected to virtually everything in the global economy.

The FX market is not as easy to manipulate as stock and bond markets, due to its size and the inter-connectedness of interest rates, FX, perception of risk and global capital flows.

To understand why the USD bull is destabilizing the global financial system, we have to go back to Triffin's Paradox, which broadly speaking illuminates the tension between the demands of domestic and global markets: one market wants a weaker currency, the other might be pushing the currency higher. Every policy that impacts the value of a currency can have a wildly divergent effect in the domestic and global economies.

I have written extensively about Triffin's Paradox (also called Triffin's Dilemma):

In terms of the USD, the basic idea is that when one nation's fiat currency is used as the world's reserve currency, the needs of the global trading community are different from the needs of domestic policy makers.

Trading nations need dollars to lubricate trading and as foreign exchange reserves that bolster the value of their own currency and provide the asset base for the expansion of credit within their own nation.

U.S. exporters want a weak dollar to spur foreign demand for their products, while foreign holders want a strong dollar that holds its value/purchasing power.

You can't it both ways. That's the dilemma and the paradox.

The long-term consequences of primary FX trends may be entirely unintended. The intention of policymakers may well be stability and growth, but as the stronger USD destabilizes periphery currencies and economies, it has unleashed a self-reinforcing feedback loop as weakening periphery currencies push capital into dollar-denominated assets.

The stronger USD reduces the cost of imports to the U.S., which means fewer dollars are flowing into the global economy, which creates a scarcity of USD that further boosts demand for USD.

All the trades based on a weakening dollar are being reversed, and this covering is adding fuel to the USD rally.

Domestically, strong global demand for dollar-denominated assets is pushing Treasury bond yields down, in effect doing the job of the Fed's quantitative easing programs without the Fed having to issue any new money. Did the Fed engineer this happy dynamic? 

Based on their public mumblings, there is little evidence that the Fed planned this domestic consequence of FX trends. I suspect the economists toiling away in the Fed are as surprised as the mainstream punditry that the rising dollar is giving the Fed the luxury of leeway that is not available to other central banks struggling with deflation, imploding currencies and massive capital flight.

What china will the rampaging USD bull break next? Maybe the Chinese economy. More on that later. 

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Are you like me? Ever since my first summer job decades ago, I've been chasing financial security. Not win-the-lottery, Bill Gates riches (although it would be nice!), but simply a feeling of financial control. I want my financial worries to if not disappear at least be manageable and comprehensible.  And like most of you, the way I've moved toward my goal has always hinged not just on having a job but a career.

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