There has been much discussion over the past few years about a currency war, but one party has been missing in the discussion, and that’s the US dollar (USD). Euro weakness, yen collapse, EM FX crash, a yuan mini-devaluation and it’s all good. The USD approaches new highs as money flows back into the US and its (relatively) high yielding US Treasury market and until quite recently its strong equity market. The world ex-US gets to live in a fantasyland of endless US consumption that they can sell into with cheap currency. One doesn’t have to be Donald Trump to see that this is not sustainable.
Amid the daily gyrations in financial asset prices, it is critical to maintain a solid grasp on the big picture framework across economies, politics, policies and of course markets, lest one get carried away in the ebb and flow. What follows is a big-picture point of view. The world needs not only to prepare for but to welcome a weak dollar. The trick is going to be in how to get it.
Why a Weak Dollar?
Mainly because there are so few other options to lift the global economy and prevent a global slowdown morphing into a global recession. That we are in a global slowdown is news to no one … what comes next is of interest to all—politicians, policymakers and investors alike.
Global growth is under pressure in large part due to three negative and mutually reinforcing feedback loops (see “2016 Outlook: And the Chickens Come Home to Roost,” published on December 21, 2015). These three negative feedback loops are the Fed rate tightening cycle, which remains in place until the Fed says otherwise; China’s economic rebalancing and reform efforts centering around the State Owned Enterprises (SOE); and the general upheaval and dysfunction in the global commodity markets. All three are anti-growth and anti-inflation. The USD links all three together.
The three feedback loops reinforce one another, as one can see, taking the Fed rate cycle as an example. As the Fed considers raising rates while other major central banks move into negative interest rate policy (NIRP), the USD is likely to strengthen further, causing more stress in the US export and manufacturing segments of the economy. In addition, a strong dollar leads to greater pressure in China as the yuan moves upward in tandem with the dollar, making life even more difficult for the SOE sector, much of which is operating at capacity utilization levels below that of 2009. Furthermore, a strong dollar tends to lead to weak commodity prices, many of which are priced in USD. Weak commodity prices pressure the broad EM space, which further weakens global demand and inflation and thus increases the risk of deflation and a debt bust.
What is perhaps most worrisome is that there is no visible policy offset to this global recession risk materializing. There is, finally, some talk from the OECD and IMF about how economies need to move beyond monetary policy alone and embrace fiscal stimulus to boost demand but very little to suggest it is anything but talk. In the run-up to the G20 and G7 meetings, policymakers from all sides are actively talking down the prospects of such, stating that economic prospects are not bad enough to warrant such coordination. Time & trend, however, are NOT our friends—a crucial insight that policymakers of all stripes and all nations seem blind to. We can have preemptive war and preemptive NYC school closings, so why can’t we have preemptive policy to avert a global recession?
This is true in the commodity space as well, notwithstanding the recent agreement between Saudi Arabia, Russia and several other oil-producing nations to freeze production at current (record) levels. A freeze is a far cry from shutting in production, and given how economies are weakening, the demand side seems unlikely to save the day.
Are talking points alone going to be sufficient to reverse the negative feedback loops already in place? It seems highly unlikely. Action will be needed—ideally globally coordinated fiscal and monetary policy. Short of that, it will be up to the US Treasury and the Fed to act. Should the Fed persist in raising rates even once or twice over the year, the likelihood would be continued dollar strength and rising prospects of recession, driven in the US by the potential for a deeper stock market selloff (see “What’s the Bull Case?”, published on January 29, 2016) and the potential for a reverse wealth effect.