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The story behind the rise in the US currency and what it means for the markets
Thursday 16 Apr 2020 Author: Russ Mould

Whatever your opinion of Donald Trump, you always know what the US president is thinking and he could not be clearer on the dollar: he does not like a strong greenback.

This is odd, because a strong currency is usually a sign of economic strength in absolute or at least relative to international peers and rivals, but the president does not want a bouncy buck and his administration has done its best to talk down the greenback.

It even worked for a while, although a sequence of interest rate hikes from the US Federal Reserve in 2018 and America’s superior economic growth record meant that economics trumped talk, if you will pardon the expression.

Then along comes the coronavirus crisis and that gives the dollar another boost. All of a sudden, investors are looking for haven assets and that generally tends to mean the world’s reserve currency. As a result, the trade-weighted DXY dollar index (known fondly as ‘Dixie’ by traders around the globe) stands back over 100 for the first time since spring 2017, just after Trump’s November 2016 election win.

Dollar dynamics

Dollar strength can therefore be a sign of concern for investors, not just presidents who fear it harms exports, as it is suggestive of fear, if not distress.

In this respect, the good news at least is that the DXY index is nowhere near the 120 level seen in 2002.

However, there are two more tangible reasons for looking at a strong dollar with some concern.

First, a rising greenback is not good for commodity demand. All major raw materials, except cocoa (which is traded in sterling) are priced in dollars, so if the US currency rises then that makes them more expensive to buy for those nations whose currency is not the dollar or is not pegged to it. Note how there seems to an inverse relationship between ‘Dixie’ and the Bloomberg Commodity Price index.

Second, emerging equity markets do not appear to like a strong dollar either, judging by the inverse relationship which seems to exist between the DXY and MSCI Emerging Markets (EM) benchmarks.

Dollar strength at the very least coincided with major swoons in EM, or at least periods of marked underperformance relative to developed markets, during 1995-2000 and 2012-15. Retreats in the greenback, by contrast, appeared to give impetus to emerging equity arenas in 2003-07, 2009-12  and 2017-18.

This also makes sense, in that many emerging (and frontier) nations borrow in dollars and weakness in their currency relative to the American one makes it more expensive to pay the coupons and eventually repay the original loans.

Zambia and Ecuador are already looking to restructure dollar debts while Argentina is still grappling with its $83bn in foreign liabilities. The higher the buck, the more uncomfortable those debts become as interest payments suck away cash that could otherwise be used for investment.

Eye of the tiger

However, there is one trend within emerging markets that is worth noting, which is how Asia is doing markedly better than Latin America, Eastern Europe and the Africa/Middle East region. Over the past year, in dollar terms, Asian stock markets have beaten all other emerging arenas and trailed only the US and Japan.

Admittedly, all Asia has done is go down less than everywhere else and many investors will take cold comfort at best from relative outperformance – they cannot pay bills with smaller losses, only income and actual profits.

It will be interesting to see if Asia can keep it up as and when global economic activity and risk appetite pick up again. Perhaps its outperformance reflects nothing more than a view that the region was first in and first out when it comes to the viral outbreak.

Perhaps it is due to the region’s much lower reliance on commodity prices, relative to Eastern Europe (where Russia dominates) and Latin America. But, given the experience of SARS in 2002-03, Asia may have been better prepared and equipped to deal with such a situation and it may be that such readiness will serve the region – and investors in it – well over the longer term, too.

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