The dollar is almighty. It is as strong as it’s been, against major trading partners, since the run-up to the invasion of Iraq in early 2003.
Almost every other currency, most prominently the euro, has been humbled. The sole significant exception is Britain’s pound sterling, which is acting like the dollar’s little brother.
Why is this happening, and what will the consequences be? The dollar has trended upwards ever since the financial crisis began in 2008 but its rally really took off in the latter half of last year. According to the trade-weighted index maintained by ICE exchange, it gained 7.7 per cent in the third quarter of last year, 5 per cent in the final quarter, and then an astonishing 10.4 per cent in the current quarter so far.
It is on course for its strongest quarter since the autumn of 1992, when the EU’s exchange rate mechanism collapsed under attack from George Soros.
The trigger for the dollar’s rise last year was the fall in the oil price. Oil transactions are denominated in dollars, and falls in oil are naturally correlated with rises in the dollar. Indeed, the dollar touched its 2008 nadir just as the crude oil price hit an all-time high.
But this quarter is different. Crude has dropped only 1.3 per cent for the year. As for the US economy, it is not conspicuously strong. A bad winter has been reflected in declining sentiment from managers and consumers.
Instead, the latest ramp-up in the dollar is down to differentials in monetary policy and interest rates. The European Central Bank has resorted to QE bond purchases, central banks across the emerging world have cut rates and bond yields in much of Europe are negative. Meanwhile, the US Federal Reserve is set to raise rates this year, with the Bank of England following some time after.
Hence the dollar’s ascendance. At one level, this is a consummation devoutly to be wished. The Eurozone needs a weaker euro, to make its exports more competitive. It is very exposed to exports.
The US is less export-sensitive and should be able to withstand a strong dollar relatively unscathed. So a strong dollar should help the US economy pull the rest of the world through.
Now come the caveats. Everyone is devaluing against the dollar at once, while US growth remains uninspiring. For manycountries, this means little help for exports.
Take South Korea. The won has dropped 11 per cent against the dollar since last summer. But as it has gained 9 per cent against the Japanese yen over the same period and 60 per cent over the past three years: Korean exporters will not benefit much.
Then there is debt. Since the currency crises of the 1990s, countries have built bigger debt markets denominated in their own currency and let their currencies float freely. The disaster of debt burdens multiplying when a country suddenly devalues need not be repeated.
But it is still an issue. Frederic Neumann of HSBC points out that dollar-based investors will want a higher yield in return for buying foreign debt. That could raise the cost of debt. And many still have significant dollar-denominated debt.
The cost of servicing that, Neumann calculates, could come to more than 0.6 per cent of gross domestic product for Malaysia and Indonesia — not a crisis but unwelcome.
Then there is the impact on profits. According to S & P Capital IQ, foreign-generated revenues account for 46 per cent of sales by S & P500 companies. A stronger dollar weakens those revenues.
Former dollar rallies have been marked by slumps in US profits. European companies stand to benefit.
The stronger dollar is only just beginning to find its way into analysts’ forecasts. US information technology companies, more dependent on foreign revenues than any other sector, have gone into reverse recently and have merely matched the S & P500 for the year so far.
In general, Thomson Reuters finds that estimated 2015 profit growth for non-energy companies has dropped from 12 per cent to 8.4 per cent so far this year. This may not be enough.
Meanwhile, European forecasts are euphoric. Brokers call for 17.2 per cent growth in 2015 earnings (after a fall last year). Those estimates sharply increased in the past three weeks as the euro tanked, fuelling an extreme rise in the valuations on European stocks.
Are they accurate? Probably not. A sudden move in exchange rates blurs perceptions. In euro terms, the FTSE Eurofirst 300 is up 21.6 per cent over the past year, against the S & P500’s 11.9 per cent increase in dollars.
But in dollars, the Eurofirst is down 7 per cent over the year and has merely matched the S & P in 2015. An apparent rally is merely an adjustment for currency moves.
But perceptions have real world consequences, such as a flow into European stocks. So far this year, BofA Merrill Lynch points out that the dollar has spurred $47 billion in redemptions from US equity funds and $36 billion inflows to European equity funds. Continued dollar gains would hurt these investors, a lot.
A stronger dollar may ease some of the fundamental imbalances in the global economy. But the confusion created by its rally brings many risks in its wake.
— Financial Times
