US dollar warns of dangers ahead

Increased global market, economic and political friction will be on the cards if signals of greenback volatility are realised.

A material strengthening of the dollar would be expected to have a leveraged impact on financial markets.

The little shiver in the US dollar overnight as traders responded to slightly disappointing economic statistics is perhaps a preview of increased volatility in currency markets, as the US Federal Reserve Board approaches another of its “do we or don’t we” moments.

The dollar has been strengthening steadily — it reached its highest levels against a basket of its major trading partners’ currencies in more than six months last week — as the markets’ conviction that there would be another rise in US rates has itself strengthened. The receding likelihood of Donald Trump winning the presidential election has also been a factor in its recent rise.

The reaction to the mixed but somewhat weak data overnight on manufacturing activity and industrial production illustrates the sensitivity to what the Fed might or might not do at either next month’s or December’s Open Market Committee meeting.

Weak data strengthens the argument of the majority of “doves” on the committee to again defer any resumption of the process of “normalising” US rates (whatever the new normal might be in the post-crisis period) that started and stopped with last December’s 25 basis point rise.

The steady rise in the dollar against the other major currencies signals something more, however, than the shifting perceptions of the probabilities of a Fed rate rise, although that is an obvious influence.

As this year has progressed, the apparent limitations of the most aggressive of the unconventional monetary policies employed by the major central banks post-crisis have started to emerge. Both the Bank of Japan and the European Central Bank, while maintaining their asset purchasing programs, have stopped pushing their official rates deeper into negative territory.

That appears to reflect a realisation that the costs of their experimental policies are outweighing the benefits — the impact on their financial institutions is destructive to their profitability and stability and, significantly, their ability to lend.

At present the ability of banks to generate profits and organic capital is being undermined, while the returns from lending to business in a negative rate environment don’t compensate for the risk for banks with weak balance sheets.

The pause by the BoJ and ECB, the markets’ reaction to Brexit and the prospect of a Fed rate rise, have seen the US yield curve — which had been extraordinarily flat — start to steepen, although yields on Treasuries did fall back slightly last night after strengthening over recent months.

There is a general view that the “new normal’’ for US monetary policy settings won’t look anything like the pre-crisis view of normal.

Financial leverage, ageing demographics and falling productivity are among the factors that Fed officials and other economists cite to argue there has been a permanent structural change in advanced economies that will dictate lower rate structures to those considered normal in the past.

Given the amount of credit central banks have pumped into the global financial system post-crisis, however, even minor shifts in interest rates and expectations can have major impacts on markets, with currencies perhaps the earliest and most visible indicator of changing conditions and relativities.

If the US dollar does continue to strengthen and US bond yields continue to edge up there will be flow-on effects, particularly in emerging markets where there is an estimated $US10 trillion or so of US dollar-denominated debt which would have to be serviced from weaker local currency earnings.

Against that, it would help Europe, Japan and China become more competitive and relieve some of the pressure on their central banks and financial systems, which are a weight on the global economy and potentially a source of threat to both growth and stability.

Conversely, if the dollar were to rise too significantly too quickly, not only might it stay the hand of the Fed, which would be concerned about a loss of US industry competitiveness, but it could generate trade frictions in an environment where the globalisation of trade has become a major political issue in the US.

A material strengthening of the dollar would also be expected to have a leveraged impact on financial markets generally, given the years during which capital has searched for ever-decreasing returns.

The US sharemarket, for instance, is selling at 20 times historical earnings, 18 times prospective full-year 2016 earnings and 16 times 2017 forecast earnings (compared to an historical average forward multiple of 14.3) even though there has been no corporate earning s growth in the US for more than 18 months.

There has been the start of a bond market sell-off; it is quite conceivable that there will be a sharp equities market sell-off as financial asset values deflate to reflect a rebalancing, probably a modest one, of the relationship between equities and bonds.

Historically, there has been an inverse correlation between commodity prices and the US dollar but whether that still holds true in the context of today’s oil and mining commodity markets is an open question.

Oil prices are being driven by excess production and any hint that OPEC might be able to reassert its influence, while prices of hard commodities have been pushed up recently by China’s latest stimulus program.

At present the market is betting strongly that the Fed will raise US rates, once, before the end of the year and probably in December, despite the mixed signals coming from its board.

Beyond that, the excessive leverage within the global economy, including the US, and the likelihood that the Fed won’t want to risk damaging the competitiveness of US companies is likely to see the “much lower for far longer’’ interest rate scenarios envisaged by senior Fed members, and the low levels of US and global growth they imply, playing out as a self-fulfilling prophecy.