Wednesday, September 2, 2020

This Week's Message: The Dollar is Key -- And -- Powell's Restless Sleep

On July 27th I wrote herein:   note the bolded sentence...

Given all that’s evolved over the past several decades, given the complete carry-dependent state of the global economy, there’s only one road for the powers-that-be to take going forward; a steady, unrelenting debasement of the US dollar.

Virtually everything the Fed has signaled since the fallout in Q4 2018 assures that all appetite for volatility has been essentially purged from their thought processes. COVID, ironically, has given them -- they presume -- complete cover to get the ball rolling sooner and more aggressively than what otherwise may have occurred. I see zero question that they’ll completely change their narrative/policy on inflation going forward, and engage in direct yield curve control indefinitely.

August 27th headline from The Economist:

"The Fed makes its biggest inflation-policy change in decades"

I titled the article snipped from above "Narrow Road Out", and explained how given a perfect storm of global factors -- a man-made (central bank-made) storm, that is -- the dollar simply cannot be allowed to rise to any great or sustainable degree without catalyzing the crumbling of the most debt-laden economic edifice of our lifetimes...

As for inflation, by definition, that means weaker dollar. So, indeed, the consensus argument that the Fed actually looks forward to higher inflation, as it does (or reflects) the needed trick with regard to the dollar, make sense. I.e., the Fed is more than happy to fuel it...

Well, yes, but no, in my humble opinion. I happen to believe that -- considering the wave of fiscal stimulus to come (stimulus paid for, by the way, by the issuance of massive amounts of government debt that the Fed stands ready to monetize), supply constraints that, while improving from the alleviation of Covid-induced bottlenecks, will be exacerbated by the push toward deglobalization, and a Fed itself that promises zero interest rates for virtually as far as the eye can see -- Powell actually fears his own success...

You see, if indeed inflation (per the Fed's favored metric) rears its head, and the Fed were to live by its old mandate, it would have to begin raising interest rates and/or reducing the size of its balance sheet. Rising interest rates would, all else equal, make the dollar an attractive haven relative to other currencies, and, to the horror of foreigners holders of dollar-denominated debt, therefore see the dollar rise in value. The ensuing unwind of dollar-funded carry (borrowing in dollars, lending/investing in foreign markets) would serve to exacerbate the dollar's upside, while tanking certain other nations’ currencies in the process.  

For idiosyncratic reasons the above scenario is playing out before our very eyes in Turkey. I.e., Turkey's high interest rate regime had created an attractive carry trade (borrow cheaply in dollars, and lend expensively in lira) opportunity for those understanding the dynamic and willing to take on the risk. 

Well, risk happens fast...

Note the Bloomberg headline from June 2018:

"Lira Carry Trade Is Back After Turkish Central Bank Boosts Rates"

Now note the Lira's rally during the second half of '18, and its precipitous decline since:

Ironically, the above look is precisely what much of the emerging world -- on balance (though perhaps not so precipitous) -- wants to see for the dollar (the world reserve currency); that's certainly the Fed's desire. But if you're an emerging nation, such a chart of your currency would mean capital flight, crushing inflation of consumption goods, and devastation in asset prices. 

Turkey CPI (ouch!), one-year through 7/31 (I suspect the next reading will be higher):

Turkish stocks:

Again, and in closing, given the global debt dynamic, a strongly, and sustainably, rising dollar scenario could be the catalyst for global contagion that would be very hard to arrest once it got underway. And while the Fed is indeed the most powerful central bank on the planet, the foreign exchange market, in two days, trades more in volume than the total value of everything the Fed currently holds on its epically-bloated balance sheet!

This, I assure you, has J. Powell restless in his sleep these days...

Thanks for reading!

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