As market disorder continues, we look at how dollar strength is impacting assets and currencies, and investigate the origins of this macro mess
US dollar reigns supreme amid market chaos
The return of King Dollar was the biggest talking point in the month of September as it remains on target to rise to its highest level against other currencies in over two decades. Though the current macroeconomic headwinds are both cause and consequence of the strong dollar, the global reserve currency’s growing momentum has unleashed a wave of interconnected market events that have left the global economy resembling a shaky Jenga tower.
Though a surging dollar is undoubtedly a boon for US imports, multinationals doing business in the US, and those travelling abroad, it has also reduced the demand for American goods overseas. Indeed, tumbling profit margins for the approximately 35% of US companies that have large international exposure is putting significant downward pressure on the stock market, with shares of the likes of Amazon and Apple Inc. both having been downgraded by Bank of America largely due to foreign exchange denting their earnings outlook.
Figure 1: The US dollar is approaching historic highs against global currencies
As successive interest rate hikes continue to spell doom for risk-on assets, both stocks and crypto are venturing deeper into their respective bear markets and many prominent investors are calling for another 20% correction in the stock market should the Fed hike to 4.5%.
Bitcoin has at least managed to hold onto the local lows from June, but the broader cryptocurrency market remains in choppy waters. Indeed, the fact that bitcoin’s correlation with the S&P 500 is presently running as high as 0.69 means that further downside in equities coupled with a rampaging dollar will likely result in bitcoin breaking support at $17,600 and targeting the next major support zone at $14K.
Global currencies implode vs the dollar
At the same time, the strength in the dollar is wreaking havoc on the international currency markets, with the euro slipping below parity with the dollar for the first time in history and all other major currencies also posting heavy relative losses.
Figure 2: Major currencies' decline vs the US dollar gathered pace in September
Most notably, the British pound fell precipitously against the dollar, briefly touching the historic low of $1.03. In this case, the dollar’s strength only added fuel to a decline already underway as a result of both the Bank of England's (BoE) “zero hesitation” policy to raise rates to prop up the pound and the fallout from the Truss cabinet’s plan to grow the economy by funding tax cuts through huge increases in government borrowing. The announcement of this ‘mini-budget’ saw UK markets go into full-blown crisis mode and forced the hand of the BoE to go on a bond-buying spree in order to keep the pension funds afloat.
Interestingly, the sharp correction in the pound was met with a sudden explosion of trading volume for bitcoin denominated in pounds sterling, which was up12x the average trading volume. Whether this is primarily due to trader/speculator activity or panicked investors rushing to shore up the value of their cash positions remains unclear, but it is most likely to have been a combination of the two factors.
Figure 3: Spike in BTC/GBP trading after pounds collapses to new lows against US dollar
Where did it all go wrong?
With the current disorder in the markets, of which the strong dollar is a major symptom, it is all too easy to forget how we got here. The high inflation that has whipped central banks into a hawkish frenzy is something that has been coming for a very long time.
Not long after the financial crisis began following the sub-prime implosion of 2007, the Fed and other central banks globally initiated “quantitative easing” programmes (aka money printing) in a bid to prevent the total collapse of the global economy. For example, from 2009-2014, the US Fed’s balance sheet exploded to $4 trillion as it loaded up on bonds, mortgages (including subprime), and other, often toxic assets in order to provide liquidity to the distressed banking sector and stimulate economic growth.
Figure 4: Today's inflationary crisis originates from the monetary expansion post 2007/8 financial crisis
It was well understood at the time that such a dramatic increase in the monetary base during this unprecedented monetary experiment would, almost by definition, carry a huge threat of inflation. Consequently, many analysts whose assumptions were based on the commonly accepted one to two year lag time between money supply expansion and inflation were beating the drum of (hyper)inflation as early as 2011.
However, these expectations were proven wrong as inflation broadly remained close to the 2% target due to much of the liquidity being mopped up by the banks who accumulated $2.7 trillion in excess reserves (an unexpected outcome of the QE programme). This meant that, though the money supply had ballooned, the velocity of money was low enough to keep currency inflation at bay and what we had instead was asset price inflation.
However, the lack of inflation didn’t mean the problem went away. When the printing presses were again fired up for the $700 billion in emergency asset purchases during Covid-19, it was accompanied by over $300 billion in direct cash payments to Americans (CARES Act). The trouble was that not only did these dollars start immediately turning over in the real economy with no intermediate banking sector to sponge up liquidity, it happened at a time when the supply of goods and services was at an all time low due to the lockdowns imposed.
This was a text book example of 'too much money chasing too few goods' and proved to be the spark that finally ignited the powder keg of inflation that had been filling up since the global financial crisis. As former BoE chief Mervyn King recently put it, the bank went 'too hard and too fast with its money printing," and we are where we are today as a result.
The problem was that central banks also printed a great deal of money and that wasn't needed… it put a lot of money into the system. – Mervyn King, Former Governor of the BoE
Safe havens missing in action
As if navigating the current landscape wasn't tricky enough, safe havens also appear to have been the first to man the lifeboats and are nowhere to be seen. Global government bonds are on course for their biggest drubbing since 1949, a situation not helped by the collapse of UK gilts following the aforementioned tax cuts announcement. Again, this has compelled investors to flock to the dollar as the safe haven of last resort, further supporting its rise.
Further, the current underperformance of gold, the prototypical safe-haven asset that should do well under normal recessionary circumstances, is yet another indicator of the uncharted waters. However, it is worth noting that with the exception of the recent boom in commodities and the US dollar, gold has lost out the least vs other asset classes and thus underlining its merits as a hedge against systemic risk (even though its inflation hedge credentials have been tarnished).
Figure 5: Despite failing as an inflation hedge, gold has declined less than other assets
Conclusion: more pain ahead as the great unwinding continues
It is difficult to foresee any quick turnaround in the current macro picture and there is no reason to believe that the high inflation and economic frailty brought on by poor government and monetary policy will be efficiently fixed by the same cohort of decision makers. Indeed, the markets have already sent ample signals of the dangers of attempting to contract the money supply after a prolonged period of prodigious monetary expansion. And with more rate hikes ahead and bond markets feeling the strain, a protracted global recession is an all but inevitable outcome – and a necessary one – in order to correct years of malinvestment, monetary easing, and economic distortions caused by artificially low interest rates.
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