Of strong dollar, sluggish global growth and sloppy financial markets

The U.S. currency as measured by the Bloomberg Dollar Spot Index has gained almost 7 percent since July, 2014. The rally up to September 2014 has seen U.S. dollar strengthening against 32 of the 33 major currencies with the exception of Chinese Renminbi.

The Russian rouble, New Zealand dollar and the Brazilian Real suffered major losses against the dollar by more than 10%. Japan’s currency has weakened against the dollar by more than 25% since early 2013, as an echo of economic reforms undertaken by the government to turnaround the economy.

The current situation is quite in contrast to the proclamation made by the Brazil Finance Minster four years ago (when the U.S. dollar fell due to an easy monetary policy) that a currency war was in the offing. But since then the situation has taken a dramatic turn.

Recent analysis conducted by HSBC has brought to light the fact that the past episodes of dollar strength have some common patterns.

A. The positive economic data reflecting U.S. growth and outlook of the economy remained stronger than its partners in its trading block.

B. Monetary Policy remained tighter than its peers.

C. The dollar loses its shine only when current account position becomes weak.

D. Global economic discomfiture in other regions adds to the firming-up of dollar.

For example, the single currency EU saw its inflation fall below the European Central Bank target of 2% in September to 0.3%. It is expected that both Japan and the EU may resort to quantum easing to combat recession. China is facing low retail price inflation.

Euro zone:
It is feared that the Euro zone may head toward a triple-dip depression, and is painted with the following situation:
1. Euro zone economies facing the risk of deflation

2. UK economy is better placed than European economy as major economies of Europe sink, but it remains vulnerable as 45% of its exports are to the stagnant EU. Bank of England policymaker Kristin Forbes has stated that an appreciating pound has cooled inflation, although its effect will fade.

3. European Central Bank is in easing mode to fight deflationary risk

4. Bond yields soaring again in Greece

5. Political trouble points in Europe: Spain, Greece, and France

6. Europe’s trade-war with Russia likely to have a negative impact on Europe, with Mr. Vladimir Putin putting an embargo on agricultural imports worth US$6.3billion from those countries/regions that have initiated a trade sanctions on Russia.

At present, all the above conditions apply favourably to the U.S. Employment numbers have improved and forecasters are upgrading the growth projections on the U.S.; and the U.S is better off than other regions.

Added to the above, a sharp decline in oil prices has also contributed to the fears of disinflation worldwide. And the Ebola outbreak is also contributing its share to the weakening of growth.

According to BBC analysis, concerns about the spread of Ebola and its impact on emerging markets have added to the worries. Companies linked to travel and tourism have seen their share prices fall in the past couple of weeks, offsetting hopes that the recent fall in the oil price would lower their long-term fuel costs.

According to Mr. Tomoyuki Kawai of Asian review, Ebola is casting a shadow trade on movements, and reported cases in Spain and the U.S. is putting investors on edge –which has had its echo on the global economy.

According to World Bank President Mr. Jim Yong Kim, the disease will likely prove a long-term drag on African economy. Ebola’s two-year financial impact could reach US$32.6billion by the end of 2015 in West Africa alone.
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A currency-war with a different style?

With global growth not rising to expected levels, a threat of deflation/disinflation is affecting global trade. As per the HSBC forecast for 2015, out of 34 countries taken up for case study only three have inflation levels above their central bank targets. In such a disinflation trend, the countries with deflation on their cards are left with the option of choosing to weaken their currencies to boost their exports and combat their sluggish local markets.

With every one of them depreciating their currencies, the only way they can effectively depreciate happens to be the U.S. dollar. This explains for the surge in the dollar. It is the wish of foreign currency forecasters that this dollar-surge against their currencies will enable them to combat their lack-lustre economies.

According to the HSBC analyst, the nature of the currency-war currently going on is also different in that global economies are keeping their currencies weak to stave off deflation — rather than stimulate growth through exports.

According to the analyst: “This is a currency-war wherein stealing inflation rather than growth is the goal”.
According to David Bloom — a London-based currency HSBC currency strategist: “A sustained gain in dollar may not be enough to push inflation back to target in those countries struggling with deflation threat, but it could buy them time to prevent inflation expectations becoming permanently detached from target.”

How long the dollar rally will continue — As explained by HSBC, the current dollar rally is unlike any that has seen before. The rally has so far been only 5%, but history shows that the average rally has been 20% and lasted for a year.

Normally, the rally is tied to USA current account deficit reaching unsustainable levels. The difference between the current rally and the ones that took place in 1980s and 1990s is that the current rally is unlikely to be tripped up by the current-account deficit getting out of bounds.

Currently, the U.S. current account deficit is about 2%of its GDP as against 6% in 2006. Hence there is scope for the rally to continue as the dollar will remain strong for a year to come.

HSBC analysis of history suggests that a 20% climb of the dollar would not be implausible. Hence, any dollar upward movement will not be stalled by current account concerns at the moment. In fact the dollar itself earlier depreciated by about 20% after two bouts of quantum easing.

Therefore, the previous decline will also make it hard for the Federal Reserve to bristle at others depreciating on their own.

“The test will be how long U.S. policymakers are willing to accept disinflationary drag of a strong dollar,” said Mr. Bloom at HSBC.

But if we look at the trade weighted dollar, it has only strengthened by about 5% and hence the predicted 20% is a long way ahead.

Strong dollar and emerging markets

From 2001 to 2010 investors got a boost from the falling dollar. But currently, due to low inflation and lack of growth, the developing markets are struggling. According to Bespoke investment group’s study on the impact of currencies on international market returns for 2013, the following facts emerge.

For investors in dollar, it is the return in terms of dollar that matters. The high returns obtaining in local markets are being eaten away by local currency depreciation. The study reveals that best performing markets are in countries with weak currencies while weak markets are in strong currency areas.

While the dollar has gained against most currencies in 2013, there are a few countries that have better local currency returns than dollar-adjusted. These include Sweden and Mexico, and to a lesser extent India and China.

But since 2013 the dollar has further gained, the markets in emerging markets will see less investments and more shifts in their inward investment flows unless they manage their currency stability to ensure an attractive return in terms of dollar.

Market volatility

According to MR. Steve Keen , the head Economics, History& Politics at Kingston University, London, the fundamentals that caused the 2007 financial crisis like debt repayment, bankruptcies, debt write-offs and inflation have not been fully addressed.

During the 1930 depression, effective steps taken at that time resulted in U.S. private debt falling almost by 100% — from a deflation spiked peak of 130% in 1933 to a low of 35% at the end of World War II. But during the 2007 financial crisis debt-cutting has been trivial — a fall of under 20% from a higher peak of 175% in 2010.

The quantum easing enabled the Federal Reserve to cover up the effects from the gravity of decelerating debt remaining at its peak in 2014. Hence the volatile market situation is likely to remain unless the private debt issue is fully addressed. But debt portfolio levels currently remaining at pre-2007 financial crisis is a worrying factor.

Tapering effect

With the US economy angling toward the Federal Reserve’s mandates, expectations are high of the Federal Reserve tightening its policies. An about a 10% pullback in the S&P 500, and the sell-off of risk assets in general are in line with the Fed’s mandate of ensuring financial stability.

Barring a marked deceleration of the economy, a rate hike around the middle of next year — 8-9 months from now — should still be seen as the most likely scenario. Minutes of the Federal Reserve September policy meeting indicate that federal officials are worried that the troubling global growth and a stronger dollar could undercut the U.S. recovery. This is amidst fear of the likely repeat of another bout of May-August 2013 taper tantrum.

But with this tall talk of a strong dollar, the recent commerce department data released during the second half of October 2014 reveals that weak U.S. economic data on retail sales and producer prices heightened concerns that the Federal Reserve will delay the interest hike as per Economic Times analysis.

U.S. commerce department data showed U.S. retail sales dropped by 0.3% in September 2014, while according to the Labour Department the prices received by U.S. producers fell by 0.01% in September 2014. This unfavorable data sent the U.S. dollar to a three-week low against the euro and more than one month low against the yen.

According to Mr. Brian Daingerfield, currency strategist at the Royal Bank of Scotland, Connecticut, “the concern that U.S. growth will slow has heightened”. But he said the strong dollar regime will continue over the long run, as U.S. growth will continue despite the latest economic data released.

This is particularly so when we see China’s consumer inflation touching a five-year low, while Japan and EU are likely to resort to quantum easing to give a push to their economies.

It is better for developing nations and emerging markets to keep an eye on the movements in U.S. dollar and its basket of currencies, and regulate their currency-stability to pave the way for investment inflows for growth.

By Sundaraju Srinath