Can anything resist the gravitational pull of the dollar?
Things are starting to break. Back in April, I suggested that there was a risk of a major event happening in the foreign-exchange markets due to the effect of the US Federal Reserve tightening rates more aggressively than its peer central banks to the backdrop of an excess of debt within the global financial system.
While that piece focused on the euro and the yen (both big losers against the dollar in 2022), the title, referring to the fallen British jewellery manufacturer Ratners, seems to be proving to be unintentionally prescient given that it is sterling’s dramatic fall which has grabbed the headlines in the past few days.
Sterling tanked on Friday in response to the UK’s new Chancellor, Kwazi Kwarteng, announcing a budget which included several unfunded tax cuts which would entail a sharp increase in government borrowing. Former head of the Bank of England Mark Carney pointed out some years ago that financially Britain relied heavily on the ‘kindness of strangers’. Any unexpected increase in government borrowing is risky, but more so when the Bank of England is hiking rates to fight inflation even as the central bank itself is admitting the country is heading into recession. Quite a cocktail.
In technical terms, the UK runs a current-account deficit whose corresponding and offsetting capital account position relies on foreign investment to balance it. A sharp deterioration in the current account resulting from these tax cuts would have to be funded either from national savings or via the capital account. Rising gilt yields and the pound falling against the dollar is the market pricing in the new cost of the kindness referred to by Mr Carney.
What can the Brits do? The country is best described as a small, open economy, and as such, doesn’t hold a large foreign-exchange reserve. The current figure is around $110b, a sum totally inadequate for the Bank of England to intervene on its own in the markets. The embarrassing experience of the failed intervention to prop up the pound on black Wednesday back in September 1992 looms large in UK Treasury and Bank of England’s memories.
The Bank of England could do an emergency rate hike. Its hike last Thursday was just 0.5% (versus the Fed hiking 0.75%, more on that below) as the members of the monetary policy committee (MPC) wanted to ‘wait and see’ what the new government budget would hold. A surprise hike might stabilise sterling in the short term, but it would not help gilt yields to fall, and the problem of government funding costs remain. Substantially higher UK interest rates would also seriously jeopardise the housing market which relies for the most part on short-term fixed rates.
Sterling has had a torrid time since it was shunted off the world’s monetary throne by the dollar after the second world war. Devalued in the 1960s and 1970s, pushed out of the exchange-rate mechanism (ERM) back in 1992, pummelled after both the global financial crisis and the Brexit vote, it now stands at just over half the level it did in 2007 before the credit crunch started.
The story of the 1984 sterling crisis is illuminating, and not just because Britain’s new prime minister, Liz Truss, is setting herself up as the heir to the country’s leader at the time, Margaret Thatcher. The real issue then, as now, is one of an overly-strong dollar.
In 1984, the UK was struggling with inflation, strikes and a number of other economic problems. The British government was aware that the Sultan of Brunei was about to move £10b of reserves into dollars, and this move would have likely caused a further fall in the pound from its then low of $1.05. The desperation of the situation was such that the government had Mohamed Al-Fayed persuade the Sultan through back channels not to move his pounds into dollars. Mr Al-Fayed’s reward was permission to snatch Harrods from under the nose of corporate raider Tiny Roland in a deal where very few questions were asked about the funding for the bid.
An immediate sterling crisis was avoided, but the ‘big’ problem of the dollar was only really sorted the following year at the Plaza Accords, an event which resulted in coordinated central bank dollar-selling to weaken the greenback and stabilise global trade. The road to the Plaza Accords and speculation about a similar event occurring in the near future to weaken the dollar is probably misplaced at the moment, especially given the current tone at the Fed.
The point is this: sterling is in focus right now. Last week (so long ago), the Bank of Japan (BoJ) was forced to intervene in the foreign-exchange markets to prop up the yen following another policy meeting in which it declined to raise interest rates. The euro has fallen below parity against the dollar and yesterday’s elections in Italy raise the unfortunate prospect of a conflict emerging between Rome and Brussels. As importantly (if not more so), the Chinese yuan has been falling as the government there seeks to deal with the effect of zero Covid and the fall out from the country’s self-enforced real-estate crisis.
What brings all these strands together is the dollar, and while 1985 saw the overly-strong dollar weakened in an internationally-coordinated intervention, the recent weakness in developed- and emerging-market currencies has come after Fed Chair Jay Powell last week reaffirmed the FOMC’s commitment to keep on hiking in order to tame inflation. This is America First in terms of monetary policy, but the problem is that the dollar is the world’s currency as well as the United States’.
Part of the dollar strength is the interest-rate differential. The yen is weaker because this year the Fed has hiked to 3.25% and the market is pricing in a terminal rate of 4.5% or possibly higher, while the BoJ still has failed to hike once. This is true also of Europe, although they appear to be getting their act together and starting to hike, albeit at the risk of causing a sovereign-debt crisis in the weaker member states by doing so. The backdrop for Friday’s weakness in sterling was the BoE hiking 0.5% on Thursday when the Fed hiked 0.75% on Wednesday. in China, the central bank has been easing in 2022 due to the deteriorating economy, and this in part explains the yuan’s weakness in dollar terms.
The other issue is energy. While the US is largely energy self-sufficient, both Japan and Europe have been forced in 2022 into current-account deficits as the cost of energy imports has soared. This is the ‘bad’ sort of currency weakness, ie one that doesn’t portend an increase in exports which would then lead to the currency strengthening again. The UK is in a similarly weak position with the new government’s unlimited post-bail out exposure to the energy market over the winter. Mr Kwarteng will be hoping for a windy winter, given the country has bet the wind-farm on renewables.
All of this helps to strengthen the dollar and weaken its peers. There is approximately $12 trillion of USD-denominated debt outside the US, and Fed hikes are making the funding in this euro-dollar market more and more expensive. This dollar-shortage is arguably forcing US interest rates higher, and this is where the dollar starts to become a problem for America as well.
The US has $31 trillion of government debt, and more at a state and local level. Because of the role of treasury securities in the short-term lending market (as a source of collateral), around half of the US debt is short-dated, and therefore highly sensitive to changes in interest rates. Depending on the maturities that are issued in the next 18 months, and depending on US Federal spending and budget deficits after the mid-term elections, a high terminal interest rate from the Fed could raise the interest bill for the Federal government to well over $1 trillion per year by the end of 2023, a sum which tax receipts will struggle to cover.
US 30-yr mortgage rates are now over 6%, levels last seen just prior to the global financial crisis. Likewise, corporates will be forced to refinance their debts at much higher levels going forward, further eating into margins which are already likely to start falling, especially for those companies whose earnings are generated abroad. Nearly a third of S&P earnings come from exports, and these earnings are due to fall as a result of the strengthening dollar and a decline in discretionary retail spending abroad due to higher energy costs, especially in Europe. It is worth remembering that in 2018 it was the seizing-up of the US credit markets which ultimately precipitated the Fed pivot at the end of the year.
All across the US economy, the effect of higher interest rates will start to make themselves felt, even if the most dramatic price shifts have so far occurred abroad, notably in the FX markets. US employment is holding up, and still seems to be the data lynch-pin of the Fed’s rate-hiking strategy. Employers, aware of the recent difficulties in hiring and retaining workers, will not to want to make cuts unless they have to, although this process has started in the tech industry. Most likely, it’ll be hours worked which will decline before lay-off’s themselves start.
Doubtless the coming weeks will be filled with activity - rumours of FX interventions, US-dollar swap lines being opened by the Fed to ease dollar funding to key ‘friendly’ countries and possibly further dramatic moves in the currency markets themselves. But at the heart of all this is the problem of the Fed hiking rates into a slowing global economy and one which is awash with debt, most of which has been issued during a decade or more of zero or near-zero rates. It remains to be seen how long it is until the Fed has to admit its current policy approach is untenable, and the US Treasury market is probably the one which will ultimately force its hand.