Beware the dollar

Written by Bruce J. Clark

April 5, 2019

In 2019 the major central banks have been focused on reflating markets by either pausing or reversing plans for policy normalization (higher rates) that hit many markets hard in 2018. Despite ongoing fears of slowing global growth, equities and commodities have so far responded positively to the prospect of easier rates and more plentiful liquidity.  

But the one thing that could ruin the party is the strength of the dollar. In my opinion the rising USD was an underappreciated factor that squeezed many regions hard last year, especially emerging economies with current account deficits. Many of these entities had borrowed heavily cheap dollars at low rates under the Fed’s QE program after the 2008 recession, leaving their fiscal position vulnerable as the dollar rose. Not only does it make debt repayment and refinancing more expensive, it also tends to pressure commodity prices that these countries often rely on for exports, creating an unenviable situation where the things they are short (dollar debt) go up and the things they are long (raw materials) go down. And as 2018 proved, because global markets are more interconnected than ever, it wasn’t long before problems in the emerging markets became a problem for the developed markets.

Normally, you would expect that the dovish shift at the Fed this year would undermine the dollar. I certainly did. As it became more apparent that the highs were in for interest rates in early Q4 last year, I assumed the same for the dollar. It was a perfectly logical conclusion given that major currencies often track the path of underlying interest rates. Wrong. Except for a few shallow dips, the dollar has been remarkably resilient. It even shrugged off the appointments of inflation doves Steve Moore and Herman Caine. In the currency world it remains the best of a bad lot and the safety and liquidity it offers in uncertain times can’t be matched. Being short hasn’t cost much money so far but the longer it remains here at the top of its range, the probability grows that the next move is higher.

The chart of the dollar index (DXY) is potentially very bullish, and a break above 97.75 would signal the beginning of a (perhaps significant) leg up. This would unleash a deflationary impulse, and much like in 2018 leave stocks and commodities vulnerable. The world needs a weaker dollar to keep the 2019 bull reflation trade going. But it may not get it.