As of July 13, the high-flying U.S. Dollar quietly rose to its highest level in 20 years, achieving parity with the Euro. And relative to the Yen, the dollar reached its highest level since 1998. Not coincidentally, commodity prices are crashing. The economist, Richard Duncan, of whom I am a big fan, foresees these trends as likely to continue. We should listen to Duncan. In my view, he is our top economic forecaster.
Driven by high inflation, The Fed’s aggressive tightening of monetary policy is driving the dollar’s appreciation. The Fed’s moves are far more dramatic than those of the ECB which, due to the significant challenges Europe is facing, including skyrocketing energy prices resulting from the war in Ukraine, make it difficult for the ECB to tighten. Japan, by contrast, is still concerned about deflation. The Bank of Japan, therefore, remains in a monetary expansion mode.
In terms of interest rates, the Fed has hiked the Federal Funds rate three times. It now stands at 1.6% and is likely to move much higher in the months ahead, perhaps climbing to 3.4% by early in 2023. The contrast with Europe and Japan is stark. The Key rate in Europe remails at 0%, while in Japan it still in negative territory at -0.1%. This disparity in policy rates has widened the yield on 10-year Government bonds, with the 10-year Treasury now more than doubling the yield on the Germany’s 10-year bond, 3.1% vs. 1.5%. Interest on Japan’s 10-year bond is only 24 basis points.
Duncan has pointed out another reason for the dollar’s increasing value. Unlike the ECB and BOJ, the Fed’s policy of quantitative tightening is already destroying a massive amount of U.S. dollars. The total volume of dollars the Fed is expected to destroy by the end of next year is $1.6 trillion.
A shrinking supply of dollars tends to make them more valuable. We can’t know if and when the ECB will begin to tighten its monetary policy. But we can project that the BOJ will continue to create more Yen. As the disparity between the dollar, on one hand, and the Euro and Yen on the other, continues to widen, the dollar should continue to strengthen. Duncan sees the potential for a profound negative effect on the global economy. The most significant outcome may be commodity prices being driven even lower.
The price of wheat peaked in March of this year. As of July 11, its price had plunged 41%. Palm Oil is down 49% since March. Aluminum and Copper have seen declines of 39%. The price of Nickel has declined by 50%. Plunging commodity prices are likely to depress global economic growth, corporate profits, and stock market valuations. Ouch!
The Impact On Emerging Markets
A strong dollar is terrible news for emerging market economies. As the rising dollar leads to falling commodity prices, developing countries that are reliant upon commodity production pay a heavy price. The likelihood of loan defaults in developing countries increases as the cost of buying U.S. dollars needed to service foreign debt becomes more burdensome.
As a result of imported goods becoming more expensive, an appreciating dollar leads to inflationary pressures in developing countries. Inflation then leads central banks to raise interest rates, making borrowing even more expensive, with the result that economic activity slows further.
Of course, problems in emerging markets can spread to advanced economies. Weakness in emerging markets can contribute to a slowdown in world trade, which has damaging consequences for developed nations. And as we saw in the 1980s' third world debt crisis, advanced economy lenders can be harmed by loan defaults in emerging nations. Duncan knows a lot about emerging economies. He has lived in Asia for many years and has long studied Asian economies. He notes the 30% decline in the MSCI Emerging Market Index and believes it has further to fall.
Because a strong share of their earnings derive from business done abroad, a strong dollar tends to also depress earnings of U.S. companies. U.S. companies’ products are made less competitive as the soaring dollar causes prices to increase. Moreover, U.S. companies earn less when foreign revenues are exchanged into dollars. As examples, Microsoft, Safes Force and Coca Cola have all recently warned of the strong dollar’s negative impact on their financial results.