The US Dollar: From Almighty to All-Powerful!
The U.S. Dollar is driving higher.
And given the underlying macro horror story, it’s unlikely to stop anytime soon.
Whenever the dollar makes a run, it usually spells a lot of problems for the rest of the world.
That’s because nearly 80% of trade transacts in USD or crosses a U.S. bank.
Why Foreign Central Banks Hold USD Reserves
The dollar makes up on average nearly 60% of FX (foreign exchange) reserves within a country’s central bank.
That’s because the central bank will use their dollar reserves to protect its own currency.
Central banks do that by selling those USD reserves to buy their own currency in the open market.
As you can see, the lion’s share of central bank foreign reserves is in USD:
Selling USD to buy its own currency helps reduce the available supply of its own currency and protects it from runs, at least temporarily.
Why Inflation Messes Up the Dynamic
Inflation throws a huge kink into that shift because fear makes investors dump the home currency the local central bank is forced to absorb.
This causes reserves to dwindle.
And without a healthy export market, a central bank, such as the Reserve Bank of India, must go into the markets to replace the dollars drained.
Why Are Foreigners Issuing in Dollars?
Many foreign governments and corporations issued dollar denominated debt starting in earnest in 2014 to capitalize on USD weakness and a new investment basis looking for yield.
A big hinderance of buying foreign debt was the need for cross-currency swaps.
Essentially, cross-currency swaps are an exchange of loans in different currencies. But they are far more illiquid than their more popular cousin, the interest rate swap.
So international entities simplified the equation by issuing debt that paid principal and interest in dollars.
As the US dollar shifts higher, the cost to pay that interest grows exponentially because they must exchange currency in the open market.
If they trade internationally, the company can use the dollar naturally flowing in to cover interest.
But as global trade slows, the cost of managing their debt burden increases precipitously.
Dollars, Dollars Everywhere
Governments are also tasked with purchasing food and energy in the market, both of which trade in USD .
Usually, when you buy wheat from Canada, you pay in Canadian dollars.
When you buy corn from Mexico, you pay in Mexican pesos.
When you buy rice from China, you pay in Chinese yuan.
But for internationally traded commodities like wheat, corn, and rice, you pay not in the local currency, but in US dollars.
And since those irreplaceable products trade in dollars, you must have dollars on hand to buy them.
And when the dollar rises in value, reserves drain faster.
Countries have been raising rates to try to get in front of inflation.
But as global prices remain elevated, foreign central banks haven’t been able to curb inflation nearly as much as they hoped.
Powell Empowered
Thanks to Jay Powell’s newly found “Volcker Courage,” it’s harder than ever to close the gap with the United States.
Paul Volcker is a legend among central bankers. Volcker was the Chairman of the Federal Reserve from August 1979 to August 1987. He is credited with destroying inflation in the United States and laying the groundwork for what became an 18-year bull market.
As you can see from the chart below, Volcker’s Fed raised interest rates to over 19% at two points. He also shrank the money supply. Both these moves stifled the stagflation plaguing the United States since the early 1970s.
Some financial commentators are drawing comparisons between Volcker and Jay Powell because Powell has found some courage to solve the current inflation problem he himself helped to create.
As dollar interest rates increase, the dollar gets stronger.
The problem is that during COVID19 every government and central bank issued a huge surge of support to boost the economy.
In plain English, they printed money they didn’t have… to pay for what they shouldn’t have… after they shouldn’t have shut down the economy.
This flooded the market with currency and has now led to a global record in rate hikes and global tightening.
Just like everyone else, the Fed is in quantitative tapering (QT) mode and that only expands as we head into September.
The rate rises and tightening liquidity are needed to absorb the excess currency around the world.
But this results in an economic slowdown.
And the cost of borrowing is increasing too fast for the markets to absorb, especially in the emerging market world.
The G7 has been carrying out some form of quantitative easing (QE) since 2008.
The G7 consist of Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States Their corresponding central banks are The Bank of Canada, the European Central Bank, the Bank of England, and the Federal Reserve.
Though they’ve been raising interest rates (rather reluctantly) in 2022, the G7 central banks have printed money like drunken sailors since the Great Financial Crisis of 2008.
They’ve acted too late and will hike too much to make up for their tardiness.
The Federal Reserve has led the way with hiking, but this has caused the USD to surge against its major trading partners’ currencies, with the euro, pound, and yen hitting decade lows.
As a result, the world has gotten drunk on cheap debt and a plethora of USD floating around.
As those dollars are absorbed, the emerging market world is going to struggle to borrow and pay for their existing debt portfolio.
“The Contractions are Getting Closer Together!”
On a global level, we are seeing the economy contract on a sequential basis, but it started in the developed world and takes time to trickle down to the emerging world.
As developed markets slow, they slow purchases and orders. That takes time to move down the supply chain.
Manufacturing has held up longer in the emerging markets, but it’s starting to rollover as the pain grows around the world.
They are still in expansion, but over the next few months we see that dipping into contraction.
It could happen much faster as the pain expands in Europe, and the whole region speedily drops into a recession.
What do we mean by pain?
As inflation takes hold around the world, it’s driven up the prices of raw materials. That, in turn, has made producing goods much more expensive. But the consumer market can only take so much. So, the producers have been eating a good deal of this inflation, not passing the higher costs onto consumers.
Recently, this has changed, as producers must raise prices to stay in business. If consumers still want producers to make their goods, they’ve got to pay up.
Inelastic goods like energy, utilities, and prescription drugs prove just how painful these costs can become to consumers. And these are goods you’ve got to have; hence, their demand is inelastic.
PPI (Producer Price Index) is an important leading indicator for inflation because companies come up with their price based on their costs.
We’ve seen costs remain elevated around the world. That will keep prices high around the world and pin global inflation at multi-decade highs.
Below are just two examples of important exporting nations – Japan and Germany – that have seen their current accounts flip into contraction.
From “Right Sizing” to “Onshoring”
Another hit to international markets is the pivot to “near shoring” or “onshoring” as companies look to address their supply chain.
According to Bloomberg transcripts of U.S. companies’ earnings calls & presentations, onshoring/reshoring/nearshoring buzzwords are being thrown around more often than ever this year, exceeding level seen in early days of pandemic.
The movements aren’t even across all countries with the biggest hit striking China and Germany.
India and Vietnam (not shown) have received help from the shift, but the movement of companies out of countries such as China affects their ability to “naturally” source USD.
US Rates Rising
Therefore, we focus on FX reserves, especially as the 10-year treasury moves back above 3%.
Typically, foreign debt is priced off the “risk-free” rate of the US 10-year.
So as the 10-year yield moves higher, it increases the cost for emerging markets to borrow.
As investors become more risk adverse, we see outflows from EM (emerging market) debt and equity. This makes it difficult for emerging countries and entities to access capital markets resulting in their local economies slowing faster.
We still believe that the 10-year bond is heading up to 4%.
Between the rise in rates and increase in volatility, the cost to emerging markets is going much higher.
It’s particularly important to remember that quantitative tightening in the U.S. is JUST GETTING STARTED!
The Fed has barely scratched the surface on tightening, and we are already seeing a reverberation throughout the system.
That means it only gets worse as we go forward.
QT is going to accelerate in September as the bond portfolio (selling) increases.
This process will pull even more dollars out of circulation and drive the dollar higher, hurting EMs further.
How The Process Works
Here is how the dynamics we are used to work: when the Fed buys a treasury bill, they put new USD into circulation.
The Fed buys the paper and issues dollars to complete the transaction.
But now the process is reversed!
The Fed sells treasuries into the market and pulls USD out of circulation.
This takes more liquidity out of the market, and it will accelerate in September as more paper is sold.
When we look at dollar denominated debt, I just pulled some samples of countries that have bonds denominated in dollars.
Here is a look at developing countries’ non-bank loans denominated in dollars:
Here is the total in the world:
Dollar denominated debt has only gone straight up around the world, with the amount of global debt sitting at record levels.
As we have global debt closing out 2021 at $303T, there is a lot of pain ahead as countries pull back on borrowing/spending.
The US Dollar quickly strengthening will accelerate the pain. And we are still at the very beginning of the surge.
As the very first chart showed, we are coming into the “Danger Zone” as US dollars rise.
We believe the DXY is heading to at least 115.
It’s revving up to make a run at the highs we saw in 2001 and 2002.
But as we showed earlier, there is much more dollar denominated debt than ever before.
This time around the pain is going to be even bigger than the 1998 Asian currency crisis.
Buckle up because we are in for a bumpy ride!
OPPORTUNITY: Buy UUP (Invesco DB US Dollar Index Bullish Fund) up to $31.
The UUP ETF tracks the Dollar Index through futures contracts. The Dollar Index tracks the USD versus the euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc. We believe the dollar will continue its run against each of these currencies.
Freedom Financial News
