Russell Silberston, Head of Multi-Asset Absolute Return
Why a strong US dollar is stressing markets
When US Treasury Secretary John Connally famously stated to his global peers in 1971 that the US dollar is “our currency but your problem”, his audience was allegedly stunned. Whilst it is not clear if his remark was an off-the-cuff comment or a brutally honest assessment of reality, his words remain as relevant today as they did nearly half a century ago.
As the world’s dominant reserve currency, the US dollar’s fortunes set the tone for global risk appetite, interest rates and funding flows.
Tightening, Trump, tariffs and Turkey
Tighter monetary policy, a surging US dollar and escalating trade tensions have rattled investors, with emerging markets such as Turkey bearing the brunt of the risk-off mood.
Markets have long benefited from a super-easy monetary policy in the US. The US Federal Reserve (Fed) is in many ways the central bank to the world. Its attitude to liquidity provision, tightening and loosening – in response to its own domestic agenda – impacts global markets significantly.
Following the global financial crisis, interest rates in the US were reduced to zero to help prop up the domestic economy. However, this was not deemed sufficient to re-stimulate lending and activity, prompting the introduction of quantitative easing (QE), which was rolled out over several phases. These actions saw the Fed’s balance sheet balloon to US$4.5 trillion in January 2015 from just under US$1 trillion on the eve of the global financial crisis. This process, however, is now reversing, and the Fed’s balance sheet is being gradually allowed to shrink back again.
With an economic recovery underway, the Trump administration undertook pro-cyclical fiscal easing, lowering corporate and personal taxation, along with higher discretionary government spending. Fiscal stimulation has boosted economic growth, emboldening the Fed to tighten monetary policy further. The Fed’s balance sheet is widely expected to shrink by another US$1 trillion, and interest rates to rise a further 0.75%.
Robust growth, coupled with higher interest rates and expectations of further tightening, has sparked a sharp rally in the US dollar in recent months. This is when Connally’s ‘problems’ start…
The introduction of QE and a zero interest rate policy in the US, ushered in an era of easy money. A decline in funding costs led to increased risk taking, capital inflows and currency appreciation. Many of the US dollars that participated in this cycle sat outside of the US, with US$9 trillion lent as far back as 2013. Of course, this process is now being reversed by the Fed’s tightening of funding costs.
This policy is pushing the US dollar higher, leading to lower risk taking, currency depreciation and increased volatility.
Market nerves have been further frayed by President Trump’s decision to escalate trade tension by imposing tariffs on a wide range of goods imported into the US. In a globally integrated economy, where producers rely on speedy deliveries and the free movement of goods across borders, these measures undermine confidence further.
Is Turkey the weakest link?
So how does the extreme volatility seen in Turkish assets fit into this global overview? Should Turkey be viewed as an idiosyncratic story or just the weakest link in those countries vulnerable to a reversal in easy monetary policy and risk taking? I would argue it is a bit of both.
Turkey has been the recipient of large US dollar inflows, which have largely fuelled a credit-driven economic expansion. With tighter US monetary policy leading the US dollar higher, Turkey is clearly vulnerable to a reversal of flows. The country’s woes are further compounded by its negative current account deficit, which implies a constant stream of inflows are needed just to stay afloat. As such, it fits the global overview perfectly.
However, policy makers have heard this story several times and know what to say and do to maintain the market’s confidence and keep the cash flowing. Typically, a currency is allowed to depreciate in order to bring a current account deficit back into equilibrium, and policy makers tighten domestic monetary and fiscal policy to ensure inflation doesn’t spiral out of control. As a last resort, the IMF often lends assistance to help an economy get back on track.
This is where the story turns idiosyncratic. Rather than following the conventional script, Turkey’s President, Tayyip Erdogan, has consistently pushed back against tighter monetary policy and ruled out turning to the IMF for aid.
Tension has been further raised by the imprisonment of a US pastor and President Trump’s imposition of tariffs on Turkish steel and aluminium exports. It was at this point that the market went parabolic and the Turkish lira went into free fall, experiencing a 40% slide in August. Thin liquidity conditions due to seasonal factors, did not help matters either.
On the ropes but fighting back
In recent days, however, the Turkish authorities have been fighting back, tightening financing conditions to deter speculation against the lira. Furthermore, the finance minister smoothed investors’ concerns yesterday1, stressing that Turkey will not impose capital controls and that the authorities recognised the need to remain fiscally conservative and ensure inflation remains well contained. In other words, the minister adopted the conventional narrative. If the authorities follow through on their word, then Turkish assets should start to recover. While the currency remains an important escape valve to ease Turkey’s need for inflows, volatility should subside again.
The US economy is booming, spurred on by pro-cyclical fiscal easing. This is leading the Fed to tighten monetary policy by raising interest rates and reducing the size of its balance sheet, which, in turn, is boosting the value of the US dollar. As the tide goes out on super-easy monetary policy, we have seen a reversal in risk taking associated with cheap funding. This is causing stress in markets that have benefited from large flows in search of yield. Consequently, we have witnessed lower emerging currency values, underlining how Connally’s words still ring true. It might be the US’s currency, but it is emerging market countries that will have to sort out their own problems.
1Thursday 16 August 2018
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All rights reserved. Issued by Investec Asset Management, issued August 2018.