The darker side of the Dollar’s Rise
Expectations of better growth are also tightening financial conditions
Expectations of stronger U.S. growth as President-elect Donald Trump opens the fiscal taps have lit a fire under the dollar—with the greenback reaching a 13-year high measured by the ICE Dollar Index. But a stronger dollar, especially given its rapid rise, has already exposed weaknesses that have been ignored by investors. There could be more.
The shift has jolted investors into action. Last week they put USD 27.5 billion into global equities, while pulling USD 18.1 billion out of bonds, the biggest moves in two and three and a half years respectively, Bank of America Merrill Lynch notes. The result is higher yields and tighter financial conditions. The pain trade has been in emerging markets, where there has been a rapid negative reaction to higher U.S. yields and a stronger dollar.
A stronger dollar means weaker currencies for some struggling regions, notably Europe and Japan. But tightening elsewhere could offset any gains these regions would get from rising exports driven by their weaker currencies.
From a growth perspective, there is a timing mismatch. If there is to be a fiscal boost in the U.S., it will take time to arrive, meaning the economic effect won’t be felt until later in 2017 and beyond. The impact of tighter financial conditions could be felt more quickly: higher U.S. yields could affect mortgage demand and the housing market, and a stronger dollar threatens to crimp U.S. corporate profits.
That said, the move in the dollar and bond yields is doing some of the Federal Reserve’s work for it, meaning expectations that are being ramped up for tighter monetary policy may yet be a little overdone. While an interest-rate increase in December looks almost certain to avoid questions arising about the Fed’s credibility, the tone the central bank strikes into 2017 will be crucial.
The 2013 taper tantrum was caused in part by concerns that the Fed would tighten financial conditions rapidly. This can be a self-fulfilling prophecy, and tough words from central banks, coupled with the recent market moves, could create a similar dynamic. Already in some emerging markets, currencies have fallen and yields have risen more rapidly than they did during the tantrum.
Meanwhile, for the Eurozone, times have changed, and 2017 looks like a tricky year. There are elections in key member states such as France, Germany and the Netherlands. A constitutional referendum in Italy that could deal a blow to Prime Minister Matteo Renzi is coming up in two weeks. Some of the decline in the euro may reflect a higher political-risk premium, particularly after the surprise results of both the U.S. elections and the Brexit vote in the U.K. Investors won’t want to get burned again.
This risk had largely been ignored until recently. This has led to an unpleasant mix in Europe: German yields have risen, but Italian yields have risen further and faster. The last thing the Eurozone needs is renewed fragmentation in bond markets. The European Central Bank is looking at changing how its bond-purchase program operates, but may face a tricky task in communicating any shift while keeping expectations of loose monetary policy intact. Markets aren’t good at reading nuanced messages, and the risk of a bad reaction is higher.
The story of 2016 is that investors aren’t great at reading the political runes. The lesson learned might be that caution is the best defence.