Benefits of a Weak Dollar
The benefits of a weak dollar are both many and widespread. Domestically, a weak dollar would help US exporters and manufacturers, both of whom are already facing recessionary conditions. Dollar weakness would likely lead to a rebound in oil prices (as the recent dollar decline, small as it has been, has helped put at least a near-term floor under oil prices). A rebound in oil prices would benefit the US energy sector as well as EM producers and those financial institutions who have lent vast sums to them, potentially averting a widespread credit crunch. Bank stock weakness, a global theme from Europe to the US, Japan and the EM, suggests concern over the prospects for a wave of defaults and restructurings is not without reason. Dollar weakness would throw a lifeline to those who have borrowed dollars offshore.
A weak dollar would allow China’s yuan to weaken in tandem, forestalling the need for an overt Chinese devaluation, which would likely cause significant global market upheaval. Such a course of action would also facilitate domestic Chinese liquidity conditions by reducing the use of reserves to maintain current currency levels. This would allow China to refocus on SOE reform, which will be costly enough on its own (labor cuts, possible reductions in consumption). Here, too, authorities are delaying the inevitable, ensuring the end process will likely be more costly than it needs to be.
Finally, a weak dollar would alleviate deflationary pressures and likely boost inflation somewhat, which in turn might facilitate slightly better profit growth and hence global stock prices. The number of references to zero-based budgeting (ZBB) in recent US company earnings calls suggests that, with low to nonexistent inflation, companies are having to cut costs aggressively to report higher earnings as stock buybacks, especially in the US, have fallen out of favor. This, of course, is disinflationary.
How Does the Dollar Weaken?
This is the tricky part, and worryingly it has become trickier as time has passed, even in the past few months since these pages first raised the topic. Several recent events suggest dollar weakness will not be an easy thing to create. First, the financial markets have priced out the likelihood of multiple Fed rate hikes in 2016, notwithstanding the Fed remaining mum on its four-rate-hike scenario. Current futures market pricing suggests it’s roughly 50-50 whether the Fed raises rates even once this year. That the USD has remained quite firm amid this repricing is worrisome, as it suggests more will be needed for it to weaken sharply ($/Y@100, euro/$ @1.20).
It implies that in order for the US Treasury and the Fed to engineer a weak dollar, the Fed will need to not just pause its rate-tightening cycle but actually reverse it, cut rates and perhaps embrace NIRP. Given the overbought nature of the USD, dollar weakness would likely feed upon itself, for example if UST euro- and yen-based returns turn negative. The difficulty here lies in the fact that it’s an election year in the US and not just any election year but a year in which anger at elites (and there is no entity more elite in US finance than the Fed), income inequality and policies perceived to benefit the wealthy are at a fever pitch.
The Fed could well face a political firestorm if it chooses to reverse itself. It’s likely that the Fed will need to see Main Street in pain, not just Wall Street, in order to have the political cover to reverse course. This of course raises the risk of a fourth negative feedback loop developing, namely that of a US stock market selloff that leads to reduced consumption via a negative wealth effect and hence a US recession as service sector weakness joins that of the manufacturing sector. The longer it takes the Fed to reverse course, the weaker the US economy, the lower the US stock market and the higher the odds of a US recession.