Written by the BullBear Analytics team
In our last post, we talked a lot about the U.S. dollar, our US dollar forecast and its impact on commodity prices and foreign currencies. We looked at how the dollar has surged since 2014, and what affect that has had on global markets. We discussed what exactly happens when $9 trillion of debt the U.S. loaned out after the 2009 financial crisis begins to be repaid. In this article, let’s talk more about why the rise of the dollar has had such an impact on the global economy.
What You Don’t Know Will Definitely Hurt You
Ben Bernanke, the (in)famous head of the Federal Reserve during the 2009 financial crisis, recently wrote an article questioning whether the U.S. dollar held an exorbitant privilege as the world’s reserve currency.[1] In the article, he attempted to downplay the dollar’s effect on global markets:
“Since the early 1970’s the international monetary system has been effectively decentralized, with each country setting its own exchange-rate framework and with the values of the major currencies being determined by markets (“floating” rather than fixed exchanged rates).”
It sounds good on paper, and other countries are certainly gaining on the U.S. in terms of economic production and output. But the dollar is still firmly entrenched as the world’s reserve currency and dominates world trade, despite what Mr. Benanke would have you believe. Yes, he’s right that the dollar is no longer the focal point of central banks around the world. We’ve even seen the IMF diminish the dollar’s role in its reserves in favor of yuan, recently.[2] None of these things are the issue.
The International Price System
“The dollar is our currency, but your problem.” – John Connally, Former U.S. Secretary of the Treasury, 1971
It is not well understood amongst the population to what extent the dollar dominates trade invoicing and pricing around the world. Most people know that the U.S. dollar is the world’s reserve currency, but have no clue what that actually means. And understandably so. Economics has been made convoluted and incomprehensible to the average citizen, and it works to the advantage of those in power. But I digress…
The dollar has a stranglehold on the world economy because it is the currency in which the overwhelming majority of trade takes place. Turkey, for instance, prices more than 60% of its imports in U.S. dollars, and only 3% in its domestic currency, the Turkish lira. This holds true despite the fact that the U.S. makes up only roughly 6% of Turkey’s total imports.[3]
Another example of the dollar’s exorbitant privilege is in Japan. Roughly 70% of Japan’s imports are priced in dollars even though the U.S. only makes up ~13% of its purchases; and Japan prices only 24% of its imports in the Japanese yen. Japan and Turkey are just two microcosmic examples of a much bigger picture of global trade.
The graphs below detail how much of a country’s trade is priced in dollars vs. the amount of trade that is actually done with the U.S. As you can see, you get a really clear picture of just how much the dollar dominates global trade.
In reference to the graphs above, the paper from which they come has this to say about the numbers:
“These invoicing shares are likely highly conservative for the dollar and euro – in reality, the dollar or euro shares are likely higher relative to the US or Eurozone trade. First, countries do not always report invoicing figures for 100% of their trade date. To be conservative, any residual was tallied as other currencies. For instance, Algeria only reported 49% of its trade in Euros. The residual 51% was ascribed to ‘Other’, even though much of it is likely in dollars. More general, currency invoicing information is scarcer for developing countries and they tend to overwhelmingly invoice in dollars (outside of the Euro area).” (Emphasis my own)
So what does all this mean for the global economy? In short, it means that the dollar is essentially a crowbar. For even the slightest movement in the dollar, the global economy experiences movement the opposite direction of an exponentially greater magnitude.
The Bubble That Can’t Burst
It should be clear by now that as the dollar ticks higher, currencies all over the world will tick lower on an even greater scale. I mentioned Turkey and Japan earlier, so let’s have a quick look at those charts. The first up is the Turkish lira. Since the latest dollar bull rally began in 2014 – a move of around 25% - the lira is down against the dollar more than 47%.
We can see the same problem with the Japanese yen. Remember that the yen prices less of its exports in dollars than Turkey, so the effect of a dollar bull market on the yen is to a lesser extent.
And from the bar graph shown earlier, Turkey and Japan are not isolated problems.
The Federal Reserve effectively squeezed one end of a balloon, expanding the other side to point of explosion and now we are seeing the pushback. Another way to think about it is that the Fed inflated a global bubble that is now coming home to roost.
The problem is that this mechanism will have a self-reinforcing effect. The dollar going up causes inflation around the world which creates a “risk-off” effect for global investors which leads to more investors flocking to the dollar. The dollar bubble is one that I think can’t “burst.” It will only continue to climb higher unless and until the Fed intervenes yet again – which I think is a high probability, but will hold off on that discussion until the next post.
The Anatomy of a Newspaper Headline
It explicitly demands your attention, and may even contain some truth – but what’s really going on here?
Another knock-on effect of the International Price System is that devaluing your currency no longer has the effect of spurring exports to the degree a central bank would like or would have you believe. The idea behind devaluing currency is that you can make your export prices cheaper, and therefore, more attractive to foreign traders.
But think about it… if your country prices most of its foreign trade in dollars, a devaluation of your domestic currency will likely have very little impact on import and export prices. Most of your country’s import and export prices stay the same while your own purchasing power gets wrecked.
The result? Hardly any wiggle room for countries to make their exports look more attractive in a strong dollar environment. This also contributes to a risk-off environment where all those printed dollars that were previously invested globally are now taken out of circulation due to investors rushing into liquid, safe-haven type assets.
And that’s exactly what we’re seeing. In the next article, we’ll talk about why the U.S. will likely experience a recession soon and how the U.S. will respond in the (highly likely) event that the U.S. dollar keeps climbing. Before we go, just take a look at the chart below. Ten year treasury yields are setting up for a substantial move lower in my opinion. As the world continues through a risk-off environment, the least risky assets will perform the best.
[1] http://www.brookings.edu/blogs/ben-bernanke/posts/2016/01/07-dollar-international-role
[2] http://www.bloomberg.com/news/articles/2015-11-30/imf-backs-yuan-in-reserve-currency-club-after-rejection-in-2010
[3] http://scholar.harvard.edu/files/gopinath/files/paper_083115_01.pdf?m=1447001475
[4] Same as above.
[5] Same as above.
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