The U.S. dollar has been strong this year, particularly in the second quarter. The U.S. Dollar Index, which measures the value of the U.S. dollar against a basket of six foreign currencies, increased 5.0% in the quarter. The Federal Reserve's Real Broad Effective Exchange Rate, meanwhile, had risen 6.1% for the year as of the last monthly report.
The strength of the dollar has been a byproduct of several factors, some of the more prominent of which are:
- The relative strength of the U.S. economy versus other developed economies
- The Federal Reserve pushing up policy rates
- The repatriation of foreign earnings by U.S. companies taking advantage of the corporate tax cut
- Foreign capital seeking higher rates of return
- Short-covering activity as it had been thought the dollar would lose ground in a synchronized global growth pickup
- Safe-haven positioning in the face of combative/protectionist trade rhetoric
It is clear to see that the demand for the greenback has gone up. What has been less clear to see -- or less talked about anyway -- is how that demand has come at the expense of many emerging market currencies, which have been weakened by capital fleeing to pursue better return prospects in the U.S.
That's all well and good for U.S. assets for the time being, yet the consequence of that flight could trigger an unintended consequence of the Federal Reserve's monetary policy, a currency crisis in the emerging markets.
A Bad Recipe
A currency crisis isn't in anyone's best interest, other than perhaps sidelined investors who are waiting to purchase assets at lower prices if the spark seen in emerging market currencies turns into a conflagration.
The concern for many with the strengthening dollar is that it makes it more expensive for countries carrying dollar-denominated debt to repay that debt.
At the same time, the capital flight typically leads to foreign central banks trying to stem that capital flight with higher interest rates that slow economic growth, leading to higher rates of unemployment and potentially civil unrest.
It's not a good recipe and it is one that can ultimately leave a bad taste in the mouth of equity investors around the globe by feeding uncertainty and stirring up volatility.
Emerging economies may have the foreign reserves to help defend their currency, but when push comes to shove -- or, really, when push comes to a run on a currency -- the will to use those reserves tends to give way to market forces.
So it is worth noting that cracks have emerged in a number of emerging market currencies, primarily because the Federal Reserve is raising its policy rate, but also because fears of trade wars are creating collateral damage among emerging market economies.
Checking on China
China's weakening yuan has been a focal point, as some pundits feel China is tacitly endorsing that weakening so that it can remain export competitive in the event the U.S. follows through with the imposition of threatened tariffs on Chinese goods.
The weakening yuan, in turn, creates problems for other economies that could potentially be forced into a competitive devaluation to defend their export share.
That is not where things are today, yet it underscores the virulent cycle that can come to fruition when currencies act as a weapon in addition to a medium of exchange.
What It All Means
With the synchronized global growth chorus being off key this year, a currency crisis would not help get it in tune. On the contrary, it would be a discordant development that would drive risk-off trading behavior that would create a swoon in global equity markets.
That isn't something that is bound to happen this summer, yet it's an emerging risk factor if the trends in the charts presented above persist.
The beneficiary of course would be the U.S. Treasury market, and, ironically, the U.S. dollar, as safe-haven positioning takes root.
Might this be what the Treasury market is sniffing out, as the yield curve continues to flatten despite the Federal Reserve signaling more rate hikes are likely on the way?
A further flattening wouldn't be good for the financial sector, which has been flattened this year in conjunction with the flattening yield curve. In turn, a stronger dollar wouldn't be good for dollar-denominated commodities and foreign holders of dollar-denominated debt.
In any case, an emerging market currency crisis would stir the pot of uncertainty and cause a summer swoon when equity markets typically languish in the summer doldrums.
(Editor's Note: The next installment of The Big Picture will be published the week of July 9)