The Over-shooting Dollar and Some Implications

The strength of the US dollar and by extension the weakness of other major currencies in recent weeks has generated a great deal of comment. Heightened global risk aversion and an investor preference for the relative safety of US assets is one reason for the dollar's ascent. But relative growth and inflation fundamentals and their implications for interest rate differentials have also been key.

The outsized degree to which the dollar has climbed based on relative growth fundamentals alone, however, is noteworthy. As figure 1 below suggests, the US dollar has advanced by much more than the incoming US data-flow would suggest. This could be because US inflation has been more broadly-based compared with other major economies (where higher food and energy prices have been principal drivers). And this has caused the Fed - in the face of a weakening economy – to signal a more active inflation-fighting monetary policy campaign relative to, say, the BoJ or the ECB.

Figure 1: The US dollar is decoupling from relative growth fundamentals

To some extent moreover the strength of the US dollar is welcome. The recent spurt higher, for example, has coincided with a peak and subsequent weakness in many commodity prices, as evidenced by figure 2. And partly as a result of this, market-based gauges of inflation expectations have also retreated to more friendly levels (see figure 3).

Figure 2: Commodity prices are responding to weaker than expected global growth

Figure 3: US inflation break-evens are responding to weaker than expected global growth

But as figures 2 and 3 above equally suggest, a key reason why commodity prices and inflation break evens have been ebbing is because incoming global growth data (i.e. global demand)) have weakened. And this goes to the point above about the decoupling of the US dollar from relative growth considerations.

Figure 4: Emerging market trade growth is now slowing down

This decoupling though –and its sponsorship by the Fed - brings into sharp focus broader risks for financial stability and global growth. Emerging market (EM) risks in particular loom large. That's because a strong dollar impacts emerging economies through a number of important channels including trade, capital flows and debt finance. On the trade front, for example, most emerging economies invoice in US dollars so a stronger dollar impairs demand for their exports (see figure 4). As for capital flows and financing, a stronger dollar almost by definition coincides with an exodus of capital from EM which magnifies external financing vulnerabilities not least for those economies whose debt stocks are heavily denominated in US dollars.

Which EM economies are most vulnerable? That depends on what we mean by vulnerable but based solely on the financing risks that are invoked by a stronger US dollar, the economies that are in the top right hand corner of figure 5 below would feature near or at the top of a list. That figure (which only includes a handful of larger emerging economies) suggest that Turkey, Chile and Colombia have a relatively high proportion of dollar-denominated debt and have seen that proportion climb quite sharply over the last 3 years.

Figure 5: High dollar denominated debt stocks in a number of major EMs

The bottom line? Not for the first time, the Fed's domestic-inflation fighting zeal is generating troublesome ramifications for the rest of the world via a firming US dollar. It's too soon to sound the alarm bells about an impending emerging market crisis. But it's worth recalling that most of those crises in recent decades have been preceded by a strong dollar.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.