When borrowed dollars become more valuable and have to be paid back in relatively less valuable currencies, the borrowed amount becomes larger as it also becomes harder to pay back.
A Bit of History
Over the last 10 years, periods of aggressive dollar strength happened in 2008 as the credit crisis began to unfold, as there was a global shortage of dollars and an aggressive move into US Treasuries, often considered the world’s safest investment.
Significant dollar strength also happened in 2014 when the Federal Reserve began discussing monetary policy tightening as other banks like the European Central Bank, Bank of Japan and most recently Bank of England have been loosening policies to encourage growth and support the export sector.
The aggressive dollar strength in the second half of 2014 was accompanied by a near crash in commodity markets, most notably the oil market. On the back of the commodity downturn, multiple commodity currencies like the Australian dollar, the New Zealand dollar, and the Canadian dollar fell aggressively against the US dollar.
As of November 9, 2016, the US dollar index (DXY) pushed higher to levels not seen since 2003, and given the 21 months of consolidation from March 2015 to November 2016, some fear the painful dollar strength seen in 2008 and 2014 may surface again.
The Trump Effect
Markets tend to move most aggressively when surprise catches them, often called exogenous shock. While Trump’s victory as US President doesn’t fit the traditional definition of an exogenous shock, also sometimes called a black swan, it does show an increasing trend of seemingly unlikely events coming to pass.
Before the US election, most economists and market participants thought a Brexit was near impossible, but the ‘vote leave’ camp won in the end. Despite the vote for the EU referendum that took place on June 24, 2016, the market is still experiencing post-Brexit shock volatility. This volatility has led to sharp moves in the value of GBP in the spot market months after the vote as many traders are still unsure how the UK economy will fare outside of the traditional relationship of the common market trade agreement of the EU.
One week after the US Presidential Election, financial markets seemed to be in a state of confused bliss. Many understand that the candidate of any election tends to have more radical views than the president or elected official. However, since Trump has positioned himself as an outsider willing to play by his own rules, many have expected his programs that would roll back the trend of globalization to benefit the dollar at the expense of other economies.
The dominant forces determining currency values are trade and capital flow. Trade comes from the order flow of exports and imports to a country. Capital comes from the order flow of investments in and out of a country.
Some think trade happening within a country offers an advantage in producing a desirable currency position more than in other countries. Much of the currency depreciation from looser monetary policy programs has been credited with providing a competitive advantage for exports being purchased globally. However, many of these countries’ economies ended up with undesirably stronger currencies due to a surprisingly large current account surplus.
Capital flows come from investments abroad where economies are stabilizing with a rate of return that exceeds the demanded risk premium of investing in a different country. In most of the world of the great financial crisis, when central banks decided to drop the reference rates to below zero in some cases in most cases around zero, economies with relatively higher borrowing rates tended to attract capital from around the world in what was known as the “hunt for yield.“
The Inflation Component
Relative inflation expectations are a core component of currency valuations. One of the easiest ways to capture inflation expectations is through the sovereign fixed-income market, and specifically by looking for higher yields. Higher yields tend to communicate and unwillingness to settle for fixed coupon payments when possible inflation is approaching that can eat away at the purchasing power of the investor, or better gains can be had in other markets like equities or commodities.
The Wednesday after the presidential election saw the US 10-year Treasury note rose by its largest intraday amount on record. The sharp move higher yields, which is accompanied by a drop in the price of the asset communicates a selloff in bonds with fixed coupon payments.
The underlying view or logic is that the super majority Congress in the United States under a Republican president that has built a career on leveraging balance sheets to build infrastructure would likely support a fiscal stimulus that could lead to inflation. Other major central banks are still battling with disinflation or deflation, and have looked at new forms of easing monetary policy.
The pending inflation in the United States upon potential fiscal stimulus could bring about a larger monetary policy divergence, much like we saw in 2014. The aggressive monetary policy divergence earned the name, ‘taper tantrum’ and was credited for partially delaying monetary policy tightening from the Federal Reserve to prevent too much discord in the global economy. However, only a few years later, we may find the Fed in the same conundrum, but with fewer alternatives.
Monetary Policy Divergence
The easiest place to see the potential for extreme monetary policy divergence is between the Bank of Japan and the Federal Reserve should the Federal Reserve began hiking rates multiple times per year. In September, the Bank of Japan introduced yield curve control. Their premise was to fix the 10-year yield at 0 percent, which would help support borrowing to finance government-induced infrastructure projects with a targeted rate of return. This type of fixed yield curve by way of government-induced buying of government debt could be considered a form of helicopter money or providing a nearly risk-free investment in government projects.
In the weeks following the presidential election the United States, we have seen the spread between the US 10-year Treasury note and the 10-year Japanese government bond widen by nearly 230 basis points from ~150bps. The extreme widening of comparable government debt securities shows the divergence of monetary policy and has played a key part and could continue to play a part in the sharp rise in USD/JPY off the 99/101 level that we saw hold this summer.
In addition to the weak Japanese yen, the price of the EUR against the US dollar has also fallen to 2016 lows after the US presidential election. Many are looking at political strife as well as potential European Central Bank easing as the Fed may be backed into aggressive tightening to tame inflation as a reason to buy US dollars against other major currencies.
The Trade Component
The trade component that has led to Dollar strength is part speculation and part deduction of logic that countries that benefited most from free trade are likely to be hurt at their expense to the benefit of the US dollar in the coming years. The logic of this argument flows from the likely change in trade agreements under the pending U.S. Presidential administration.
On Monday, November 21, 2016, President-elect Donald Trump noted that he would look to withdraw the United States from the Trans-Pacific Partnership or TPP. Specifically, Trump declared, “I am going to issue our notification of intent to withdraw from the Trans-Pacific Partnership, a potential disaster for our country. “Instead, we will negotiate fair, bilateral trade deals that bring jobs and industry back onto American shores.”
The TPP has Japan and the United States along with other Asian economies with the potential for China to join and shows President-elect Trump’s desire not to participate in trade deals where the United States does not have a positive net present value. Shortly after Trump stated his intent to take the U.S. out of the TPP, Prime Minister Shinzo Abe of Japan noted that you would fall apart without the United States involvement stating, “The TPP would be meaningless without the United States.”
While the TPP is one example, it is helpful to display how the United States may begin to pull out of intended trade deals that could put the macroeconomic ideal of global free trade on its head.
Additionally, as smaller economies or those with net trade surpluses like export-dependent or commodity-dependent countries start to feel the potential trade wrath of the new administration, there could continue to be an unwind of anticipated trade flow. Such a reversal could continue to see the USD strengthen and a weakening of other currencies that are dependent on external trade and financing.
What to Watch Going Forward
For a shortcut on what to watch, keep an eye on the dollar index to see if the 14-year highs continue. Another key financial market to watch would be government debt and more specifically the spreads between comparable maturity government debt like the US to Japan 10 year yield spread.
If the yield curve and spreads continue to widen, it would likely be indicative of further dollar strength and likely Yen weakness as well as weakness in other negative interest rate currencies. Another sovereign debt market to watch is the US 2-year yield. The US 2-year yield is seen as a proxy for anticipated Federal Reserve policy over the coming years. Over the last two months, we have seen the US 2-year yield move from ~75 basis points to near 110 basis points. Given the tendency of the Federal Reserve to hike by 25 basis points when they deem appropriate, such a rise in the two-year yield indicates 1½ hikes by the Federal Reserve have become priced in since the election through 2018.
A further rise in two-year yield would indicate more aggressive action by the Federal Reserve in light of anticipated inflation, which could further cause the strong trend in the US dollar to accelerate.
In addition to sovereign debt, traders can keep an eye on the performance of emerging markets relative to the U.S. Dollar. As of late 2016, popular emerging markets that could give a tell of further USD strength on a broader scale would be the South African Rand, Mexican Peso, and Chinese Yuan.
