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15 April 2020

Dollar Melt-Up

This article was written by Richard Horswill. All views and opinions expressed are strictly his own.

The very same financial schemes and processes that were employed during the crash of 2008 are once again being used to support the global financial system in the wake of the Covid 19 pandemic. This time, however, we are seeing what could be described as stimulus on steroids.

Tackling a deflationary episode has been widely debated, but we have left the decision making in the hands of central bank economists. Their continuing attitude has been to attempt to stop, at all costs, a deflationary depression like 1929. Instead, the mother of all bailouts has been deemed necessary, with unsurpassed interest rate cuts, quantitative easing to provide lashings of liquidity to businesses to stave off insolvency, and this time round, alongside all of the monetary stimulus, Governments around the world are providing fiscal stimulus in the form of cheap loans, grants and direct payments to the common man in a form of universal basic income sometimes known as "helicopter money." How this all plays out will be interesting to say the least but one thing for sure is that free markets won't be with us anytime soon.

One possible scenario that is mooted, based on the current bailout solution, is the prospect of a dollar “melt-up" meaning that dollar strength will prevail regardless of all the monetary stimulus rather than the usual dollar collapse theory. The consequences of this point to inflation.

Fundamentally, the dollar, as the global reserve currency, is the only game in town for global businesses. Thus, there is significant demand outside the borders of the United States for dollars. International trade is primarily transacted in US dollars, but also dollar denominated debt outside the US requires dollars for servicing. This is where the Federal Reserve has decided to step up, not only to provide domestic liquidity but liquidity on a global scale. This can happen in a number of ways; in support of business with the purchase of corporate bonds via QE but also in support of other central banks via dollar swap lines being provided. Both scenarios provide liquidity to maintain solvency. This is particularly important for example in the case of a financial centre like Hong Kong. The Federal Reserve provides a US dollar swap line for HK business with dollar denominated debt to access US dollars. This is particularly pertinent in the case of Hong Kong as their currency is pegged to the dollar and if the HK dollar loses too much value their central bank has to buy HK dollars and sell US dollars. A dollar swap line provides for liquidity in the event of US dollar shortages.

These policies may provide short term relief however, as fractured supply chains take time to restart alongside the negative demand shock which is decreasing global demand; a negative feedback loop could develop with the requirement of more and more dollars emerging as a short squeeze for dollars is created by the lack of productivity and demand. Also, a possible black hole of dollar monetary destruction due to potential defaults could well exacerbate the short squeeze as dollars disappear from the system. Thus, to counteract US dollar strength, further stimulus would be needed firstly to maintain money supply and secondly to attempt to devalue the dollar (more money printing!).

The implications of a picture like this on a medium term basis (six to twelve months) could well provide the conditions for inflation in consumer goods (but deflation in other areas such as housing and car purchases as interest rates would have to be adjusted to accommodate any inflationary spike). More digital currency units chasing fewer goods feeding the inflation monster may well provide the starting point to a loss of confidence in local currencies. The US dollar being global and continually in demand would maintain its upward trajectory, placing more pressure on dollar denominated debt outside  the US. The monetary medicine provided by the Federal Reserve, however, also has "a sell by date", and if confidence is eroded in the dollar an even more significant inflationary event may result. The most likely scenario would be stagflation (defined as persistent high inflation combined with high unemployment and stagnant demand) with annualised inflation reaching levels seen in the 1970's of around 15-20%. The more extreme end of an inflationary crisis would be hyperinflation, generally defined as an inflation when prices of goods and services rise by more than 50% per month.

We are in unprecedented times so it may well be worth looking into generally unprecedented financial conditions. Sadly the resilience of the global financial markets has been lacking since the last crisis and we have been plunged into life support mode once again. We have outsourced our financial futures to a trusted group of individuals who claim that they have control of the levers of the global financial machine. We will over the coming weeks and months be able to see if these career academics are as clever as they think they are!! 

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