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Markets crack as the dollar gets weird
Are U.S., U.K. economies on the brink?
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Markets reeled last week, an ominous acceleration of a slide that’s seen virtually every asset class enter bear market territory over the last several weeks. The S&P 500 fell for the third quarter in a row for the first time since the Great Financial Crisis, and bonds are in their worst year since at least 1926. Economic comparisons to the late 1920s or 2000s should concern everybody.
What exactly is happening? At its core, this emergency is arising from a bizarre contradiction in the U.S. economy: rising inflation alongside rapid dollar appreciation. These two things aren’t supposed to be happening at the same time, but the unique nature of U.S. political and economic dominance makes it both possible and extremely risky. And just like always, working people and the Global South face the biggest threats of all.
How can we have both exceptionally high inflation and the most valuable U.S. dollar in a generation? First, the dollar’s value in this context means the performance of the dollar index, a comparison of the dollar to a basket of currencies from around the world. So we can also frame the dollar’s strength from the other direction: the rest of the world’s currencies are getting weaker.
This is because the United States is exporting its inflation through its monetary policy, part of the “exorbitant privilege” of issuing the world’s reserve currency. Here’s how it works:
The Fed fights inflation by raising interest rates and tightening its balance sheet.
Deposits at the Fed and affiliated U.S. banks pay better now, so foreign capital moves into the U.S., squeezing their domestic currencies.
Even worse, these depositors often need to sell their euros, yen, pounds, etc. to get the dollars to put in the United States. Markets get flooded with these other currencies and demand for the greenback goes up.
This means these countries face rising energy and industrial costs, so their central banks try to reverse the trend. They need to buy their currencies with their dollar reserves, increasing dollar supply and stimulating demand for non-dollar money.
But these central banks don’t hold their dollars in cash -- cash doesn’t pay interest. They own U.S. Treasury bonds, and to turn the bonds into dollars, they need to sell them.
This fire sale drops Treasury bond prices, which raises their interest rates (prices and rates always move in opposite directions), doubling down on the problem that started the whole process. This also reduces dollar supply and increases demand, further appreciating the currency, also driving the feedback loop.
Bottom line: rising interest rates make the dollar more attractive, and capital around the world is flowing out of other currencies and into the dollar, raising its value.
This export of U.S. inflation around the world only works until important things start to break, things like the British economy. The United Kingdom got a rude awakening about its declining place in the world as markets responded to a Thatcherite fiscal policy announcement under new right-wing Prime Minister Liz Truss like they would to similar pronouncements from “emerging market” economies -- moving capital out of Britain as quickly as possible.
Gone are the days when that government could run up large deficits with impunity as long as they came from tax cuts and not social spending. The prospect of a big new supply of U.K. sovereign debt -- bonds known as “gilts” -- led investors to dump the asset as fast as they could. Pension funds rely on bonds to pay out interest at the same time the funds need to pay out benefits, a strategy known as “duration matching.” The gilt plunge hammered pension fund balance sheets, prompting their bankers to demand new collateral, a.k.a. margin calls. If they’d had to meet them, they would have sold off assets to come up with the cash, accelerating the melt down.
The Bank of England came to their rescue on Wednesday, announcing that it would buy up gilts to stabilize their price -- just the sort of emergency interventions that become more and more necessary as systems and regimes buckle under their own dead weight.
In the meantime, investors are responding to the uncertainty by cashing out as much as they can and parking it in the one asset that’s still going up -- the U.S. dollar. This means even more feedback loop, even more risk.
Remember: the Federal Reserve’s strategy is doomed to fail -- or maybe doomed to succeed. The Fed hopes that by making money more expensive, businesses will hold off investment, lay off workers, and slow down demand to meet structurally insufficient supply. But those supply problems are a function of production chains that took decades to build being totally reorganized in just the last two years. The more they try to fix it, the more they create crises like the one unfolding now.
It remains to be seen how long it takes them to learn this and what they’ll do when they get there. Until then, expect more weird things to keep happening with money.
Our only investment advice: Logan might have been right.
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