The incoming Trump administration's policy mix is strongly reflationary, with the prospect of:
- Increasing economic growth
- Increasing inflation
- Increasing interest rates
- A Fed tightening monetary policy
- Significantly worsening public finances (see here)
- The potential repatriation of over $1T of US corporate cash overseas.
Most, if not all, of this is likely to favor a stronger dollar. This could lead the US towards a more protectionist stance.
Dollar strength has well known effects on trade flows, but the effects on financial flows are less well understood. Dollar strength puts pressure on parties with large dollar liabilities.
That in itself is nothing new, but as the Bank of International Settlements (BIS) has shown, this works through the banking system via hedging operations. Here is Hyun Song Shin of the BIS:
"...if a global bank lends to EME corporates as well as engaging in hedging operations that accommodate local life insurance companies and pension funds, then any pickup in measured risks in the corporate lending book will erode its risk-taking capacity to provide hedging services to these pension funds and life insurance companies."
Apparently, the stress to balance sheets can be such that free money is left on the table when dollar strength leads to periods of deviation of covered interest rate parity. Remarkable indeed.
This is why Shin is arguing that the dollar index is replacing the VIX as a better fear gauge.
Here we consider the effects on the world economy. Dollar strength is, on the whole, favorable for China and especially Japan and the eurozone. Basically, it's a mechanism by which some of the US reflation is transmitted to these economies.
As such, it constitutes a positive spillover effect. The eurozone is already in the crossroads of a negative spillover effect from the (likely) change in US policy in the form of higher interest rates, which is something it can do without.
Japan especially has been given a shot in the arm by the stronger dollar. A couple of months or so ago, the yen hovered just above 100 to the dollar and the Nikkei had plunged to 15,000.
Now it has gotten a new lease of life, with the yen recovering 10% in a month and the Nikkei performing strongly as well (obviously driven by the fall in the yen).
A lower currency not only boosts exports and hence growth, it also boosts domestic inflation, which is what Japan dearly needs. One of the goals of Abeconomics was to bring inflation back to 2% to get Japan decisively out of its deflationary rut, which has played havoc with debt dynamics.
But after three years and an unprecedented monetary blitz, this goal has hardly inched closer, so any help from abroad is good news for Japan.
Something similar can be said about the eurozone, although here the problems are more internal. The euro isn't overvalued, but internally, competitiveness of member countries are out of whack.
In the first decade of the euro, before the financial crisis, capital flowed from the North to the South, as a result of the removal of exchange rate risk. The resulting monetary expansion in the South resulted (amongst other things) in an accumulation of inflation differentials which in the end became rather substantial (in the order of 20-30%).
That is, the South lost competitiveness, but within a single currency, this is very hard to recoup. Embarking on deflation has helped only a little, but that has made debt dynamics much worse.
The whole eurozone system suffers from a deflationary bias as all the adjustment is forced on the deficit countries, so here as well we can say that help from abroad in the form of a stronger dollar helps, a bit, even if it doesn't resolve the internal adjustment problem.
However, since the deviations from covered interest rate parity involve the USD against developed market currencies like the yen, the euro and the Swiss franc, it is apparent that their banking system feels the stress when the dollar rises, which leads us to assess the financial spillovers.
The above only assumes the trade effect of a strengthening dollar, but these days of a highly leveraged and interdependent world financial system, these can be easily trumped by financial flows and balance sheet effects.
We already mentioned above that periods of deviation from covered interest parity, which should offer risk free arbitrage opportunities, can only be explained assuming banks are unwilling and/or unable to 'lend their balance sheet' for such operations as these are already stressed from debtors with dollar liabilities.
This isn't entirely reassuring, and it could get ugly if further deterioration in their clients' balance sheets as a result of further dollar strength leads banks to clamp up further.
In extremis, this could provoke something akin to what happened in the aftermath of the demise of Lehman brothers, a freezing of the financial system, or at least a crucial part of it.
We aren't there yet, and hopefully we never will, but one might keep these problems in mind for the moment. The main risk points here are China, emerging markets, and European banks.
We've already discussed this situation in a couple of previous articles, so we can be brief here.
China fixes its currency to a basket of 13 currencies, and the rising dollar means that the yuan gradually depreciates against the US dollar. As we argued in an earlier article, we don't think this is unwelcome in policy making circles.
We've also argued that no real panic ensued after the November forex reserves data were released, which showed a fairly substantial decline of $69.1 billion, taking the reserves down to just above the psychological $3 trillion level.
This is because Chinese companies have substantially reduced their dollar debts to a more manageable $430 billion.
The danger is when the yuan depreciation becomes disorderly, further dollar strength really isn't helpful with respect to that, let alone any trade frictions between the US and China (for instance, as a result of the widening trade gap produced by the higher dollar).
There are two possible negative channels:
- While equity markets are rejoicing, the stronger dollar might make it considerably more difficult for companies with a lot of overseas exposure to deliver on the earnings front.
- If a higher dollar causes trouble elsewhere, for instance in emerging markets (see below), this will come back via financial channels and markets might instantly jump in a 'risk-off' mode. Reactions are likely to worsen a crisis though, as capital will flow back to US based assets putting even more upwards pressure on the dollar.
It's here where most of the problems lie. Many companies in emerging markets have gorged on US dollar denominated debt. According to the BIS (from UNCTAD):
"According to the Bank for International Settlements, the debt of non-financial corporations in these economies increased from around $9 trillion at the end of 2008 to just over $25 trillion by the end of 2015, and doubled as a percentage of gross domestic product (GDP) - from 57 per cent to 104 per cent."
Now, not all of that is denominated in US dollars, but nevertheless:
More than $3 trillion still is (and this is just corporate debt). This is very sensitive to US rate rises and a dollar rise, here is The Telegraph:
The Bank for International Settlements says a complex web of global hedge contracts automatically forces banks in Europe and Japan to shrink their balance sheets when the dollar rises, cutting off oxygen for emerging markets and debtor regions. This invisible process is known as the global "dollar shortage" and can be extremely powerful.
So a triple whammy is possible:
- A rising dollar increasing the outstanding debt
- Rising interest rates increasing the financing cost
- Dollar shortage reducing access to refinancing possibilities
Perhaps it is becoming a bit clearer why the BIS argued that the dollar index is replacing the VIX as the best fear index.
Repatriation of US profits parked abroad as a result of tax changes and movement of capital towards the developed world as a result of higher yields could worsen the dollar crunch.
And indeed, in the wake of the Trump victory (from Bloomberg):
Investors are fleeing funds that focus on the debt, yanking a record $6.6 billion from emerging-markets bond strategies in the week ended Nov. 16, according to EPFR Global data. The debt is poised for its biggest monthly loss since the so-called taper tantrum of 2013.. Companies in these more-vulnerable economies have $340 billion of debt coming due through 2018, and they are going to have a hard time paying all that back if investors keep withdrawing their cash.
But there are also more optimistic sounds, and a few big institutions that are buying into emerging market bonds, like BlackRock, Amundi and Morgan Stanley. Their bullish arguments (according to Bloomberg):
- Political risk in the developed world is increasing
- Attractive yields, after the recent rises
- Declining default rates: "The default rate in emerging-market high-yield bonds will more than halve in 2017 to 2.1 percent after reaching a seven-year high this year, JPMorgan Chase & Co. said in a research note published Nov. 23."
- Better EM fundamentals with weaker currencies and smaller current account deficits.
- Under investment in EM, there is ample scope for more funds to join in.
One could also notice that there has been some recovery in some of the commodities, which also shores up many emerging market funds.
However, we know from the Asian crisis in the second half of the 1990s that problems can start in just one country (Thailand), with contagion spreading like wildfire to other weak spots.
That crisis was quite remarkable and it might be instructive to revisit some aspects, here is the IMF:
For the three decades before Asia's financial crisis, Indonesia, Korea, Malaysia, and Thailand had an impressive record of economic performance - fast growth, low inflation, macroeconomic stability and strong fiscal positions, high saving rates, open economies, and thriving export sectors. It is therefore not too surprising that no one predicted the Asian crisis.
And here on the causes:
The underlying causes of the Asian crisis have been clearly identified. First, substantial foreign funds became available at relatively low interest rates, as investors in search of new opportunities shifted massive amounts of capital into Asia.
Does this ring a bell? It gets even scarier:
Third, in the countries affected by the crisis, exports were weak in the mid-1990s for a number of reasons, including the appreciation of the U.S. dollar against the yen, China's devaluation of the yuan in 1994, and the loss of some markets following the establishment of the North American Free Trade Agreement (NAFTA).
Higher dollar? Check. Weaker yuan? Check. Only the third element is absent, for now. But world trade is already strangely lagging world output, and Trump might turn protectionist at any time.
In fact, the higher dollar could be key here on several fronts:
- It increases the local currency value of the corporate dollar debt in emerging markets.
- It leads to a further dollar shortage through the availability of bank funding.
- It is likely to widen the US trade deficit and could trigger the protectionist in Trump.
What to buy?
In the meantime, as long as there isn't an acute dollar crunch or an emerging market going off the deep end, the higher dollar is particularly beneficial for Japanese shares.
The Nikkei has already staged an impressive comeback, but this is likely to last as long as the yen keeps falling against the greenback.
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.