The Consequences of a Strengthening US Dollar: Charles Hugh Smith

It actually creates destabilization
Wednesday, November 12, 2014, 10:21 AM

In early September, I made the case for a rising U.S. dollar, based on the basic supply and demand for dollars stemming from four dynamics:

Demand for dollars as reserves

  1. Other nations devaluing their own currencies to increase exports
  2. “Flight to safety” from periphery currencies to the reserve currencies
  3. Reduced issuance of dollars due to declining U.S. fiscal deficits and the end of QE (quantitative easing)

Since then the dollar has continued its advance, and is now breaking out of a downtrend stretching back to 2005—and by some accounts, to 1985:

 

 

(Source)

Technically, the Dollar Index has broken out of a multi-year wedge:

So what does this mean for the global economy?

Since currencies are intertwined with virtually every aspect of the global economy—trade, credit, inflation/deflation, commodities and capital flows, even political and soft power—there is no one consequence, but a multitude of interactive consequences.

For U.S. households, the rising dollar will have gradual, generally marginal effects: our dollars will buy more euros and yen when we visit Europe and Japan as tourists, imports from countries with weakening currencies will be slightly cheaper (if the importers don’t palm the difference as extra profit) and we may be competing with more foreigners for dollar-based assets such as American homes, oil wells and Treasury bonds.

In sum, a rising dollar will only affect households on the margins. Since roughly 85% of the U.S. economy is domestic, imports and exports have relatively limited influence on the entire economy.

In other words, the direct consequences of a stronger dollar on U.S. households are generally positive, with the exception of those working in price-sensitive export industries, where the rising dollar will make goods sold in countries with weakening currencies more costly.

But the secondary effects could end up being far more consequential for Americans and everyone else on the planet, for this reason: the centrality of the dollar in the global economy means that the effects of a stronger dollar can create potentially destabilizing dynamics.

Central Banks Are Responsible for the Heightened Risk

One primary reason for this expansion of risk is the unprecedented actions of the world’s central banks since the 2008 Global Financial Meltdown. In effect, the central banks doubled down on debt and leverage as the politically expedient “solution” to the implosion of credit and leverage (what we call de-leveraging) as the collateral underlying highly leveraged loans (think subprime mortgages on overpriced McMansions) evaporated like mist in Death Valley.

Any solution that forced the write-down or write-off of the mountain of bad debt would have collapsed the over-leveraged banks which had become linchpins in the global financial system.

So the only way to maintain the status quo and avoid handing massive losses of wealth to financial elites was to issue trillions of dollars in new credit-money, lower interest rates to near zero and start buying assets from private-sector owners, turning their assets into cash that could then be used to invest overseas or in domestic stocks and bonds.

Each major central bank injected unprecedented sums of new money into their economies to ease the refinancing of debt at lower interest rates and enable expansion of credit for new loans.

If each economy (or in the case of the European Union, currency region) was moated by strict capital-control regulations, this massive goosing of credit might have been contained within each economy.

But in today’s world of digital finance, capital, credit, risk and interest rates all flow wherever the risk is perceived to be controllable and the return is greatest.

Let’s pause for a moment to recall that risk in 2008 was perceived to be controllable right up until the day that Lehman Brothers declared bankruptcy and the global financial system erupted in a fireball of panic and liquidation.

Why was risk considered controllable right up to the implosion? Derivatives and hedges were widely assumed to be solid protection against any spot of bother in global credit markets. But this confidence was misplaced, as it ultimately relied on multiple counterparties retaining their solvency.  If a position was hedged by a derivative that was to be paid by a counterparty if things went south, and the counterparty blew up before the hedge could be paid off, there was no hedge.

It turned out that liquidity—a market of buyers and sellers that allows any security to be sold more or less whenever the seller decides to sell—dried up, and markets for risky securities went bidless, i.e. there were no buyers at any price.

If there are no buyers, the value of the security drops to zero, and everybody down the line who counted on that security fetching the anticipated price so their hedge could be paid off also implodes.

Central banks countered this implosion by buying bonds and mortgages and lowering interest rates so old debt could be refinanced at much lower costs.

But in doing so, they created a vast market for global carry trades—the borrowing and buying of assets in various currencies to take advantage of yield and interest-rate differences.   In the old pre-digital days, it was difficult to arbitrage these variations in national currencies and interest rates. But in today’s world, it’s easy for financiers and financial institutions to borrow money in dollars or yen at low interest rates and re-invest the money in higher-yield securities issued in other countries.

The Problem with Carry Trades and Cross-National Debt

Read more

The Consequences of a Strengthening US Dollar: Chalres Hugh Smith | Peak Prosperity.

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