The Dollar’s Ascent: What It Means For Global Markets And Investors
The strength of the dollar in recent months is not only a rebound from oversold levels but has been driven by the threat of a global trade war initiated by the implementation of broad and significant tariffs by the United States on imports. One of the results that history suggests can be expected if tariffs are implemented, along with a slowdown in the global economy, is the use of currency devaluation by America’s trade partners to make their exports more price competitive.
Therefore, further strength by the dollar, partly derived from its role as the world reserve currency in turbulent times, will be magnified by the effects of the potential trade war that looms. The conspicuous strength of the dollar will have pervasive effects on the global economy and for investors that will be felt in all asset classes. One sector that will feel the effects of a soaring dollar especially keenly will be foreign issuers of dollar-denominated debt who will see the cost of their borrowing surge.
The accompanying chart illustrates the explosion in U.S. dollar-denominated debt held by foreign banks (which has doubled since the 2008 Financial Crisis). The chart explains how these institutions borrow U.S. dollars, and the role of “swaps” used to hedge interest rate risk on the underlying $65 trillion of US dollar-denominated debt.
In addition to this $65 trillion can be added a further $12 trillion from the borrowing activities of foreign governments and governmental institutions. Together, this debt represents a defacto short position in the dollar of $77 trillion that will be increasingly squeezed by a rising dollar that will exert mounting pressure on banks and the financial system generally. The demand for dollars to cover this implicit short position will amplify the upside pressure on the American currency.
The prospect of a surging dollar is just one of a host of potential economic and geopolitical catalysts for significant market volatility in the months and years ahead. We remain confident in our expectation that the balance of the 2020s will be unusually turbulent and an exceptionally challenging environment for investors.
The volatility we anticipate will present considerable risks, but also great opportunities for prepared investors. Active investors who practice effective risk management techniques will be richly rewarded while inattentive, passive investors are likely to be punished.
Each month in the Global Investment Letter I update my investing activities, as well as comment on major global equity, fixed income, currency, and commodity markets.
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