A short article in the US print edition of the Financial Times Weekend publication warrants careful attention. It does not trigger an immediate change in behavior but it does suggest something I have already predicted, that may warrant a change soon. Firstly, the article is called, “Dollar Strengthens as EM Exodus Gathers Pace“, by Roger Blitz and Jennifer Hughes. The point drawn is that even though the markets had a fraught time last week, the dollar quietly strengthened as investors continued to turn away from emerging markets and toward apparent strength in the US economy.
This is having the affect of lowering EM currency values compared to the dollar, and increasing the dollar value against other currencies. This imports to the US become less expensive (worsening the US trade deficit) and exports become more expensive. But trade with the world is not as significant percentage of the American economy as with some other large economies, I hear you chide. Yes, that is true, but the point is emerging markets and other countries, and firms, price many or much of their debts and loans in dollars, since it has attracted seriously low rates and is a reliable currency. As more money flows toward the dollar, the value goes up compared to other currencies, and the amount of sell local currencies one has to sell in order to buy dollars to repay that debt, goes up.
The article explores the Chinese efforts to control its “free” currency. Of course it is devaluing, carefully, against the dollar. But the market is stronger, and more trigger-happy. The People’s Bank of China (PBOC) has changed the way it values the renminbi against the dollar in order to soften any direct change in value with the dollar by using a broader basket of currencies. It is entered the market several times recently and sold vast amounts of its dollar exchange reserve to help slow the fall of its currency against the dollar. The efforts are many, the impact are adequate, so far. But the market is something you struggle to fight against and you hope you never have to.
Then you have to add in the fact that the US Federal reserve diverged from the rest of the central banks around the world with a rate rise, albeit small, in December. This is what is triggering the dollar rise – apparent faith in a stronger US economy. But as the market is so volatile, small changes lead to big impacts. As the imbalance between EMs and the US continues, the Fed may in fact be motivated to reverse direction to send again converge with the EBC, Bank of Japan, and the U.K. and revert back to more easing by reversing its interest rate rise. Not solely due to currency challenges but to the impact of those currency impacts on global trade and the entire economic system.
I love the phrase quoted toward the end of the article. “Investors were used to the Fed getting ‘intimidated by the whiff of grapeshot’, said Steven Englander, FX strategist at Citigroup. But the US economy might be resilient enough to sidestep deteriorating financial market conditions.” If not, the Fed may yet lower interest rates before they raise them again.