What If The Weak Link Of The Global Economy Is Not Yuan Or Oil, But The U.S. Dollar?

by: Ranjit Goswami


Reviewing current market turmoil and reasons attributed to it.

The reasons of weak oil, and more so the weakening yuan do not seem to have enough merit. Weak dollar solves much of the problems.

The problem may be with the strong dollar likely to be stronger myth. Dollar should not be strong, and going forward, it should weaken further based on fundamentals.

Dollar Since the beginning of 2016, global financial markets have been passing through an extreme bout of negative sentiments, and selling pressure. In the United States of America, all indices like S&P 500, Dow Jones Industrial Average (DJIA) have corrected and the Nasdaq 100 have corrected quite sharply. The daily volatility has been high as index futures have often not been an indicator of the index closing. In Europe, major markets have touched 13-month low, China's markets (Shanghai, not Shenzhen yet) are approaching their last August lows. Japan's Nikkei index is similarly approaching its last January lows. India, the so-called bright spot as it does not have excess capacity like China, rather underutilized capacity, and is a net commodity importer, therefore the so-called 'bright spot' as the World Bank loves such terms, are at its 19 month-lows.

In China, the Shanghai Composite Index (as did Shenzhen index) faced circuit breaker, and markets closed abruptly for two days. The circuit breaker, a new system that was tried out to reduce market volatility but resulted in the opposite, what usually happens when people who do not understand market takes up policy-making. On the 2nd occasion, the market barely lasted for 29 minutes. In India, without oil exposure or excess commodity exposure, its PSU banks have come under huge short-selling pressure as RBI Governor wants to clean up their balance sheets at one drastic aggressive surgery, without working out the details of the operation itself, as the patient is is being walked into the Operation Theatre.

As usual, a lot of opinions to theories are being suggested in the global media, more so in the 24X7 TV news media, some of which exclusively focus on the financial asset classes. The predominant of that, in the beginning of this downturn, was with China's currency: On how China's central bank, the People's Bank of China (PBoC) might have been trying to weaken yuan with its daily setting rates, as the spot rate can vary maximum 2% either way.

Before this issue could be stabilized (whether yuan fixing rate on a daily basis showing a downward trend, which matter of fact is not), what emerged is the difference between Yuan's onshore and offshore rates as naturally there has been an attempt to attack offshore Yuan rate. Once even that onshore-offshore yuan rates stabilized with no significant differences, the drug administered naturally did shoot up Shanghai Interbank Rate (SHIBOR), equivalent to London Interbank Rates (LIBOR), as no government can and should encourage currency attackers. The best thing always is to nip in the bud itself.

Once that too happened, as China rightly acted in its priorities by squeezing supply of yuan in Hong Kong market available for shorting yuan first and then regularizing it, on the 14th January, against a blood of global financial markets, China's market stabilized by being the single exception in Asia. Today, on 15th January, it again tanked. And those opinions do not stop…the explanation shifted from China to weak oil prices to global geopolitical instability theories arising from low oil prices on daily basis, based on what seems to be the flavor of the season. Crude oil, in between, did hit lower than the psychological $30/barrel mark as well.

On top of all of above, there are uncertainties as the Federal Reserve of the US came up with its first rate hike in December, and since then, there has been speculations on whether there are two or three or four more in the cycle in 2016. In spite of the rate hike, the 10-year US bond yield has gone down significantly since the last rate hike, hinting that market thinks otherwise.

There may be a little bit of truth in all of above. Market actions can never be deciphered fully, although there can be root causes. 2008 financial crisis had one single root cause, originating from the US.

The present situation, as of now, is nowhere near 2008, but no one knows the future. Unlike the 2008 crisis, as of now, the problem seems to be not originating from any single nation as such. At the most, one can single out China and its huge capacity that has caused commodities (ex-crude oil) prices to tumble to decade's low level in many cases, and/or it can be the OPEC nations along with American fracking and all oil producing nations and firms not aggressively cutting supply as supply remains higher than the demand. Alternatively, one can talk about the debt level in different nations, be it in government, companies or in household - including how central banks' balance sheet got expanded as debt shifted there in the US or other Western economies as well as in Japan. In case of China, similarly the PBoC balance sheet has huge forex holding, lately which has seen some reduction.

What has not been explicitly stated in much of above, but implicitly repeated again and again in innumerable articles and opinions is the strong dollar hypothesis, probably taking the form of a huge myth. Nearly most Western analysts believe that we already have a strong dollar, which is likely to be stronger with the American economy doing reasonably better and the Fed on its rate hike cycle.

Kennedy said: "The great enemy of truth is very often not the lie--deliberate, contrived and dishonest--but the myth--persistent, persuasive and unrealistic." Here, given above background, we review what has been given for guaranteed, without questioning…the strong dollar hypothesis.

What if the strong dollar hypothesis itself is wrong, but market has been desperately trying to stick to it? Not long ago, everyone in the US administration was asking China to appreciate its currency (Bloomberg, 2011; and WSJ as late as Oct 19, 2015): 'yuan is "below its appropriate medium-term valuation" quoting from the semiannual report of the currencies from the US Treasury Department), suddenly everyone sees it is overvalued when the latest trade data showed nearly $58 billion (382 billion yuan) trade surplus. Oil may be going through a disruptive innovation from shale and fracking, but at current prices, be it for oil or for much of the commodities, be it iron ore to steel to aluminium and other base metals, significant percent of global producers have been making losses, in many cases more than 50% of capacity is not sustainable at current prices, whereas the supply glut is barely 2-5%.

Much of the global problems get solved if dollar itself weakens, and it should, based on fundamentals of American economy. As of now, the strength of the American economy was judged compared to its peers like Japan, UK or the other European counterparts, having strong currencies and currencies in IMF's SDR basket. If the parameters based on which the Chinese economy is judged, if the same yardsticks are applied to the US; be it trade competitiveness, savings rate, indebtedness and who have been lending the money to America, and how sustainable that source of money is (be it China or OPEC nations like Saudi Arab), one may see that the weak links are not the oil or yuan or China.

The elephant in the room, as the weakest link in the current turmoil may well be the myth that the United States of America's dollar is strong now and is likely to get stronger. Yes, it is strong now but it cannot sustain this strong value - and therefore must come down.

The market needs to adjust to that, if this school of thought has some merit. And this adjustment, if it happens over a real long period of time, it is likely to be relatively smoother. If one tries adjustment in the opposite direction as the case now has been, there is likely to be both short-term and long-term pain. Question is: can it get scarier than what the trailer of 2016 has so far been?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.