The biggest macro story of the year has undoubtedly been the US Dollar rally. Beginning in April of this year, this rally ended the global synchronized growth narrative, threw the precious metals market into a tailspin, and led to debt crises in Argentina and Turkey. After a sharp initial rally, the dollar has entered a consolidation pattern. The chart below can be interpreted in one of two ways: 1) a head and shoulders top, meaning the dollar will pull back significantly. 2) a wedge, meaning the dollar could once again pop to the upside. One thing remains certain—we are at a critical juncture in the DXY. What happens to the DXY this week could dictate the narrative in global financial markets for the rest of 2018 and going into 2019.
(Source: Twitter, @RaoulGMI)
Why the Dollar Matters
With oil and most other commodities priced in dollars, every country in the world must have a portion of their reserves in the dollar to settle trades. Additionally, many foreign countries and corporations have taken advantage of a weak dollar and low rates in the United States by binging on dollar denominated debt. Foreign governments and corporations may take out dollar denominated loans from international financial institutions such as the IMF or private commercial banks at better rates than domestic institutions. They also have the option of issuing bonds in dollars. Emerging market countries and corporations oftentimes issue bonds in a currency with a more stable track record because it attracts more investors and investors will not demand higher yields for taking the risk involved in an unstable currency. The chart below demonstrates how dollar denominated debt in emerging markets exploded after 2008.
(Source: The Wall Street Journal)
At the time of its recent crisis, Turkey had $460 billion worth of short term foreign debt, most of which denominated in dollars. Turkey earns in the Lira but services much of its debt in dollars. When interest rates and the value of the dollar rose against the Lira, Turkey had a difficult time fulfilling its debt service obligations. Additionally, as the rising dollar hurts international economies and currencies, many international investors run to the dollar as a safe haven asset. In a self-reinforcing pattern, dollar strength oftentimes leads to more dollar strength.
What Happens if the Dollar Falls?
Under a rallying dollar, the iShares Emerging Market ETF (EEM) is down 10.95% YTD. The Shanghai SE Composite Index, hurt by both trade wars and a rising dollar, is down 18.91% YTD. Additionally, with investors turning to the dollar as a safe haven asset instead of gold, the SPDR Gold Shares ETF (GLD) is down 8.60% YTD. If the DXY breaks to the downside, emerging market countries will have an easier time paying their dollar-denominated debt and investors that fled emerging markets under the auspice of a rallying dollar will begin bringing their capital back to emerging markets. Investors will also ditch the weakening dollar as a safe haven asset and look to buy gold. Take a look at the two charts below. Gold and emerging markets move opposite against the value of the dollar. If this is indeed the end of the dollar rally, gold and emerging markets are screaming buy at these distressed levels.
(Source: Tradingview.com, author)
(Source: Tradingview.com, author)
What Happens if the Dollar Rises Again?
If the dollar breaks to the upside, expect more pain in emerging markets, especially those countries with high external debt and inverted balance sheets. An inverted balance sheet is one in which the liabilities and assets have opposite correlations. For example, when the Lira falls against the dollar, Turkey’s liabilities (mostly in dollars) increase while their assets (mostly in Liras) decrease. This self-reinforcing cycle makes such countries vulnerable to debt crises as occurred during the Asian financial crisis of 1997.
Fitch, the US ratings agency, conducted a study on countries most vulnerable to a rising dollar based on factors such as dollar denominated debt (sovereign and corporate), stability of monetary policy, government expenditure to revenues, soundness of the banking sector, and an "other" section that looks at political and military developments such as conflict in Ukraine and authoritarian tendencies in Turkey that may scare potential investors. Turkey and Argentina have already entered debt crises based on the recent dollar rally. According to their study, Ukraine, Brazil, and South Africa will be placed under extreme pressure in another dollar surge. Ukraine especially so, as it has high external debt, high corporate debt, and a weak banking sector. Owning US dollars and US equities will be the only safe bets in another dollar surge. Bold investors could even consider shorting emerging markets or the vulnerable currencies and countries mentioned in the study. They should also consider buying emerging market securities as they continue to reach new lows.
(Source: Business Insider)
The dollar has one fundamental tailwind that leads me to believe the dollar rally may continue: Quantitative Tightening. Quantitative Easing led to an explosion in the monetary base from $825 billion in 2007 to $4.1 trillion by the end of 2015. Increasing the money supply to such an extent debases the currency and serves as a headwind to dollar strength. Quantitative Tightening, or allowing the bonds bought during Quantitative Easing to reach maturity, shrinks the global supply of dollars. Meanwhile, demand has not changed. One must ask, is the dollar rally overblown? Or perhaps it is just getting started given the current global supply and demand dynamic for dollars. I believe we will have our answer soon. When other global central banks begin normalizing their balance sheets or when the Federal Reserve begins loosening monetary policy once again, I expect the dollar to weaken. However, if QT continues to be the catalyst that drives the dollar higher, those effects will reverberate through the emerging and precious metals market, leading to more debt crises in the developing world.
Keep your eye on the dollar at this critical juncture. A break to the downside could spell an end to the troubles in gold and emerging markets. If that is the case, they may be good assets to own at these levels. Meanwhile, a continuation to the upside could lead to more debt crises in developing countries and more pain for investors in emerging markets and gold. In the event of another dollar surge, investors should consider shorting emerging markets or waiting to buy as they reach new lows. Countries such as Ukraine, Brazil, and South Africa find themselves extremely vulnerable if the dollar rallies again due to their high levels of dollar denominated debt, poor monetary policy and pubic finances, and banking sector weakness.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in EEM, GLD over 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.