The US Dollar Hits a 35 Year High

The US dollar has been on a tear rarely if ever seen before. This has been helped by soaring interest rates. For example, we began the year with the bellwether 10-year Treasury bond at 1.6% while last week’s auction saw rates above 4%. While the nominal change does not seem that large, the percentage change is enormous.

The accompanying chart takes the form technical analysts call “parabolic” because, after years of basing, it has recently gone virtually straight up completing the shape of a parabola. While it may yet go higher, the parabolic blow-off phase usually marks the end of big market moves. The chart (courtesy of stockcharts.com) shows we are now in such a rare parabolic event.

Momentum indicators like relative strength and MACD (a measure of how high a given market has pulled away from long-term moving averages) indicate that on a momentum basis, the dollar is now historically overbought. The shorthand way of expressing this technical setup is to say the dollar has moved too far too fast.

Unfortunately, that does not by itself pronounce the dollar move over, as it may continue soaring for a while.  Markets can stay overbought until they die of exhaustion. But experience with parabolic markets suggests we are now getting into the final innings of this game, and that usually means something in the financial system “breaks” when such moves are made. What could they be?

A number of news stories suggest some very large international banks and trading firms are being hurt. The recent stock action for example, in Credit Suisse, indicates market players think they are capital impaired and in danger of collapse. Could it be this cycle’s Lehman Brothers? The risk is that financial firms trade with each other, and when one fails, it causes others huge losses and the pain spreads. Economists call it financial contagion. Anyone with a recent memory of what happened with Bear Stearns and Lehman Brothers in the 2008 financial crash remembers what transpired when the dominos start to fall. Recall that even firms as large and established as Merrill Lynch had to be sold to Bank of America, and then the banks themselves needed a government bailout. It was ugly and scary.

Another worrisome factor is those big recessions, the ones that can cause social and political turmoil, tend to be international in nature. And, you can’t get much more international than having the reserve currency, the currency used to price and settle most commodities like oil, rise this much relative to other currencies. Moves of this magnitude affect everyone trading in dollars, those holding dollars, and those that owe dollars, which is just about the whole world.

Looking at it the other way, the Japanese Yen is down about 30%, Pound Sterling is down over 20%, and the Euro is down over 20%. Some foreign central banks are now trying to “intervene” to support their currency.

There are a lot of countries with dollar-denominated debt they must service. With the dollar so high, they must pay off the debt today with dollars much more expensive than those originally borrowed. If they can roll the debt forward, now they have to pay much higher rates than just a year ago. For the marginal debtor, that is a country or corporation not in the best of financial shape, the combination of a strong dollar and higher interest rates to refinance, can be the straw that breaks the camel’s back. This raises the risk of default, not just from indebted corporations and financial institutions, but even for sovereign country debt.

In terms of trade, things are being thrown all out of whack. Take Japan as an example. Japanese goods are now 30% cheaper in dollar terms. That gives them an unearned competitive edge in international trade. We say “unearned” because they are more competitive because of a soaring dollar and a falling yen, not because they suddenly became 30% more productive through hard work and innovation. But on the other hand, Japan must buy commodities with strong dollars, which adds 30% on top of the already monstrous advances in prices these commodities have made in dollar terms. Currency shifts can both help and hurt at the same time.

A soaring dollar also hurts the earnings of multinational corporations.  Some 40% of the earnings of the US S&P 500 comes from overseas, and for a number of corporations like Philip Morris and Mondelez, almost all their earnings come from overseas. Such a strong dollar makes them uncompetitive in many markets.

What currency turmoil can create is a lot of uncertainty and markets don’t like that.

This has the potential to touch off global trade wars and competitive devaluations, something most economic historians warn against because that happened in the Great Depression of the 1930s.

Years of ultra-cheap money have caused a lot of financial excesses. Large currency swings will tend to reveal where the weakness is, but once revealed, there is not a lot that can be done about it.

To paraphrase Warren Buffet, it is only when the tide goes out that you discover who has been skinny dipping.

Among those caught naked may well extend beyond market speculators and apply to international banks, governments, and their central banks.

Just this past week, the Bank of England, which was raising interest rates and shrinking its balance sheet (Quantitative Tightening) much like the US Federal Reserve, suddenly reversed course and said they would buy bonds in whatever quantity is necessary to stabilize the bond market for government bonds that came close to melting down. But you can’t fight inflation without raising rates and shrinking bank reserves, so the policy was instantly contradictory. And if an economic policy can turn on a dime like this, the central banks themselves become a major source of economic instability. The irony is their very existence is predicated on the notion that they are supposed to be a stabilizing force within a supposed unstable free market. That is just not the way things are turning out.

What is being laid bare here are the spendaholic politicians and the central bankers who have for so long, accommodated the political and financial excesses of their respective governments. It is the age-old problem of central planning and the use of inflationary policies by politicians.