By Jay Pelosky, J2Z Global Advisory, LLC
Originally Published in Itaú Global Connections Year VI Issue #204
There has been much discussion over the past few years about a currency war, but one party has been missing in the discussion, and that’s the US dollar (USD). Euro weakness, yen collapse, EM FX crash, a yuan mini-devaluation and it’s all good. The USD approaches new highs as money flows back into the US and its (relatively) high yielding US Treasury market and until quite recently its strong equity market. The world ex-US gets to live in a fantasyland of endless US consumption that they can sell into with cheap currency. One doesn’t have to be Donald Trump to see that this is not sustainable.
Amid the daily gyrations in financial asset prices, it is critical to maintaining a solid grasp of the big picture framework across economies, politics, policies and, of course, markets, lest one get carried away in the ebb and flow. What follows is a big-picture point of view. The world needs not only to prepare for but to welcome a weak dollar. The trick is going to be in how to get it.
Why a Weak Dollar?
Mainly because there are so few other options to lift the global economy and prevent a global slowdown morphing into a global recession. That we are in a global slowdown is news to no one… what comes next is of interest to all – politicians, policymakers, and investors alike. Global growth is under pressure in large part due to three negative and mutually reinforcing feedback loops (see “2016 Outlook: And the Chickens Come Home to Roost,” published on December 21, 2015). These three negative feedback loops are the Fed rate tightening cycle, which remains in place until the Fed says otherwise; China’s economic rebalancing and reform efforts centering around the State Owned Enterprises (SOE); and the general upheaval and dysfunction in the global commodity markets. All three are anti-growth and anti-inflation. The USD links all three together.
The three feedback loops reinforce one another, as one can see, taking the Fed rate cycle as an example. As the Fed considers raising rates while other major central banks move into negative interest rate policy (NIRP), the USD is likely to strengthen further, causing more stress in the US export and manufacturing segments of the economy.
In addition, a strong dollar leads to greater pressure on China as the yuan moves upward in tandem with the dollar, making life even more difficult for the SOE sector, much of which is operating at capacity utilization levels below that of 2009. Furthermore, a strong dollar tends to lead to weak commodity prices, many of which are priced in USD. Weak commodity prices pressure the broad EM space, which further weakens global demand and inflation and thus increases the risk of deflation and a debt bust.
What is perhaps most worrisome is that there is no visible policy offset to this global recession risk materializing. There is, finally, some talk from the OECD and IMF about how economies need to move beyond monetary policy alone and embrace fiscal stimulus to boost demand but very little to suggest it is anything but talk. In the run-up to the G20 and G7 meetings, policymakers from all sides are actively talking down the prospects of such, stating that economic prospects are not bad enough to warrant such coordination. Time & trend, however, are NOT our friends – a crucial insight that policymakers of all stripes and all nations seem blind to. We can have preemptive war and preemptive NYC school closings, so why can’t we have a preemptive policy to avert a global recession?
This is true in the commodity space as well, notwithstanding the recent agreement between Saudi Arabia, Russia, and several other oil-producing nations to freeze production at current (record) levels. A freeze is a far cry from shutting in production, and given how economies are weakening, the demand side seems unlikely to save the day.
Are talking points alone going to be sufficient to reverse the negative feedback loops already in place? It seems highly unlikely. Action will be needed – ideally globally coordinated fiscal and monetary policy. Short of that, it will be up to the US Treasury and the Fed to act. Should the Fed persist in raising rates even once or twice over the year, the likelihood would be continued dollar strength and rising prospects of recession, driven in the US by the potential for a deeper stock market selloff (see “What’s the Bull Case?”, published on January 29, 2016) and the potential for a reverse wealth effect.
Benefits of a Weak Dollar
The benefits of a weak dollar are both many and widespread. Domestically, a weak dollar would help US exporters and manufacturers, both of whom are already facing recessionary conditions. Dollar weakness would likely lead to a rebound in oil prices (as the recent dollar decline, small as it has been, has helped put at least a near-term floor under oil prices). A rebound in oil prices would benefit the US energy sector as well as EM producers and those financial institutions who have lent vast sums to them, potentially averting a widespread credit crunch. Bank stock weakness, a global theme from Europe to the US, Japan, and the EM, suggests concern over the prospects for a wave of defaults and restructurings is not without reason.
Dollar weakness would throw a lifeline to those who have borrowed dollars offshore. A weak dollar would allow China’s yuan to weaken in tandem, forestalling the need for an overt Chinese devaluation, which would likely cause significant global market upheaval. Such a course of action would also facilitate domestic Chinese liquidity conditions by reducing the use of reserves to maintain current currency levels. This would allow China to refocus on SOE reform, which will be costly enough on its own (labor cuts, possible reductions in consumption). Here, too, authorities are delaying the inevitable, ensuring the end process will likely be costlier than it needs to be.
Finally, a weak dollar would alleviate deflationary pressures and likely boost inflation somewhat, which in turn might facilitate slightly better profit growth and hence global stock prices. The number of references to zero-based budgeting (ZBB) in recent US company earnings calls suggests that, with low to nonexistent inflation, companies are having to cut costs aggressively to report higher earnings as stock buybacks, especially in the US, have fallen out of favor. This, of course, is disinflationary.
How Does the Dollar Weaken?
This is the tricky part, and worryingly it has become trickier as time has passed, even in the past few months since these pages first raised the topic. Several recent events suggest dollar weakness will not be an easy thing to create. First, the financial markets have priced out the likelihood of multiple Fed rate hikes in 2016, notwithstanding the Fed remaining mum on its four-rate-hike scenario. Current futures market pricing suggests it’s roughly 50-50 whether the Fed raises rates even once this year. That the USD has remained quite firm amid this repricing is worrisome, as it suggests more will be needed for it to weaken sharply ($/Y@100, euro/$ @1.20).
It implies that in order for the US Treasury and the Fed to engineer a weak dollar, the Fed will need to not just pause its rate tightening cycle but actually reverse it, cut rates and perhaps embrace NIRP. Given the overbought nature of the USD, dollar weakness would likely feed upon itself, for example if UST euro- and yen-based returns turn negative. The difficulty here lies in the fact that it’s an election year in the US and not just any election year but a year in which anger at elites (and there is no entity more elite in US finance than the Fed), income inequality and policies perceived to benefit the wealthy are at a fever pitch.
The Fed could well face a political firestorm if it chooses to reverse itself. It’s likely that the Fed will need to see Main Street in pain, not just Wall Street, in order to have the political cover to reverse course. This, of course, raises the risk of a fourth negative feedback loop developing, namely that of a US stock market selloff that leads to reduced consumption via a negative wealth effect and hence a US recession as service sector weakness joins that of the manufacturing sector. The longer it takes the Fed to reverse course, the weaker the US economy, the lower the US stock market and the higher the odds of a US recession.
Outside the US, the passage of time combined with other central bank actions has meant the road to a weak dollar is longer and perhaps more winding than it would have been even a few months ago. In a highly indebted world, the price of delay is high and rising – something to keep in mind while financial asset prices gyrate up and down.
The decisions by the ECB and BOJ to engage in NIRP has led to the collapse in rates in Europe and Japan to the point where out to five, seven and even 10 years, government bonds have negative yields, making the 10 year UST yield at 1.75% seem mighty appealing. NIRP has also led to questions about bank profitability and hence further increased the odds of a broad, potentially global, credit crunch. There is a small ray of sunshine and that is that a broad basket of EM currencies has actually slightly appreciated versus the USD over the past month, reflecting perhaps the precarious stabilization in commodity prices.
Difficult or not, the world and the US need a weak dollar. A big part of the problem is that each central bank is doing what it thinks best for its mandate and its domestic economy. The Fed thought it was doing the right thing when it raised rates in December while the BOJ clearly thought it was doing the correct thing when it entered NIRP after decades of avoiding such a policy. The ECB and its decision to enter NIRP likewise reflect its assessment of what Europe needs to boost inflation. With helicopter money drops now being discussed in the Financial Times (see “Helicopter drops might not be far away,” by Martin Wolf, published in the Financial Times on February 23, 2016), it is clear the bottom of the monetary policy barrel is being reached, with subpar results and rising collateral risks. What lies beneath is more than just the title of a scary movie.
A 21st Century Plaza Accord Is Needed
When viewed in this light, it becomes clear that what is needed is a 21st Century Plaza Accord. The Plaza Accord refers to the 1985 meetings where the major economies of the day, led by the US, agreed to actively intervene in foreign exchange markets to bring down the value of the USD, which had appreciated greatly in the preceding years. The Accord was successful in sharply reducing the value of the USD, particularly against the yen. This helped to boost the US economy but also led to Japan adopting an expansionary monetary policy that helped lead to an asset bubble, the bursting of which continues to bedevil Japan to this day.
It is hard to see who would lead such a modern-day gathering, given the lame-duck nature of the Obama administration and the limited heft of others in the global economic sphere. Upcoming G20 (Finance Ministers this weekend, summit in September, hosted by China) and G7 (May, hosted by Japan) meetings may see more attention than in the recent past, but it would be a big surprise indeed if something akin to a coordinated policy to weaken the dollar were to come about. It’s just about possible to envision a coordinated policy of CB easing, but beyond a bounce in global equity markets, it’s hard to see what more easing will do for the global economy.
One could wish for a coordinated policy of fiscal and monetary adjustment to boost global demand and sop up some of the excess supply swamping both primary and finished products, but that seems even less likely. As noted previously, fiscal policy in the US is in the freezer till mid-2017, at least given the electoral cycle. Europe, in a way that is becoming quite depressing, has managed to throw yet another monkey wrench into its adjustment process with the Brexit discussions, which will now complicate matters through the summer at least. Japan may have some fiscal room, perhaps, for a pre-election supplementary budget but more likely a decision to hold off on the spring 2017 consumption tax, which may help Japan but is unlikely to move the global needle.
The Plaza Accord made history not only because it was successful but also because it gave Japan a seat at the international monetary system table. The first meeting of the G20 took place in November 2008; the 2016 iteration would be a perfect place to launch China’s more active role in the world monetary system. In fact, two of the summit priorities, breaking a new path for growth and creating a more effective and efficient global economy and finance governance structure, suggest an opportunity.
Given that China is not party to the G7 meetings, the G20 would seem to be the ideal locale to deepen China’s integration into the global monetary system. A 21st Century Plaza Accord could also provide cover for Fed policies that may otherwise prove politically unpalatable. What would it look like? The Fed reverses course, the US Treasury and others actively intervene to drive down the dollar, Germany and the rest of Europe commit to fiscal stimulus, China acts on SOE reform, Japan delays its consumption tax, etc.
What is needed is a weak dollar – the dollar is the global linchpin, the key that can address the negative feedback loops threatening the global economy. How will a weak dollar come about: a new Plaza Accord, a Fed-led policy reversal, a combination of the two? Who among the geo-economic leadership will grasp the nettle? Time will tell, and as noted above, time is not our friend. In the interim, equity rallies should be sold while sovereign bond selloffs should be bought. Rather than wish for the US to rescue the global economy via its consumption, the world should wish Janet Yellen Godspeed and embrace a weak dollar.