The Fed's 'Super Dollar': How Much Longer?

The inverted yield curve is not that big a problem, says Rafael Bostic, CEO of the Atlanta Fed. Two more rate hikes are coming, says Esther George of the Federal Reserve Bank of Kansas City. Anyone hoping for a reprieve in the strong dollar just had a bucket of cold water thrown on them by the two Fed officials

Jerome Powell, chairman of the U.S. Federal Reserve. A strong dollar has always been a headwind for emerging markets
Jerome Powell, chairman of the U.S. Federal Reserve. A strong dollar has always been a headwind for emerging markets

A strong dollar is a headwind for any commodity exporting country because it usually means lower commodity prices. A strong dollar is always a negative for emerging market currencies, as that is where the dollar flexes its muscles most, as opposed to Europe and Japan. Weaker Indian rupees and Chinese yuans may be good for exports -- it makes their goods less expensive. But it is a negative for other matters, including paying off dollar-denominated debts.

Emerging market equities are 180 basis points away from a bear market. The MSCI Emerging Markets Index is down 18.2% from the highs reached on Jan. 26. The S&P 500 is down around 0.3% over the same period.

Bostic did mention the threat of trade wars undercutting the strong dollar scenario and further rate hikes, but did not mention the words emerging markets, China, or Turkey, whose currency has been crushed this year, down over 60% against the dollar. The Argentine peso is even worse, down 63% this year. The Brazilian real isn't do too well, either. It's lost around 25%, though this has more to do with the political risk associated with the upcoming election than the Fed. The Russian ruble is down 18%. The South African rand is down 16.2%. India's rupee is off around 10% this year against the dollar.

The dollar has gained heavily against the currencies of Turkey, Brazil, Russia, India and South Africa
Picture: Yahoo! Finance via Bukket
The dollar has gained heavily against the currencies of Turkey, Brazil, Russia, India and South Africa

The Fed exerts a lot of pressure on emerging markets. Turkey is an example here. It's under the most stress, followed by Argentina.

Brad Setser at the Council on Foreign Relations, a noted expert on balance of payments flows, noted this week that Turkey's budget deficit is about 3% of GDP and fiscal debt is 30% of GDP. Setser thinks the emphasis as far as Turkey and the strong dollar is concerned should be on Turkey’s banks and their large stock of dollar-denominated debt. Those banks are the main reason why Turkey’s currency crisis could morph into a funding crisis and that would leave Turkey without sufficient foreign currency reserves to pay its debts.

"The narrative is that Turkey’s banks have a maturity mismatch....and will start taking losses quickly if domestic interest rates rise too high," says Neil MacKinnon, a senior economist with VTB Capital in London. "From a balance sheet point of view, the risk of a run on the banks’ foreign currency funding poses far larger vulnerabilities than the government’s funding needs," he says.

Turkey's President Recep Tayyip Erdogan
Photo: ©
Turkey's President Recep Tayyip Erdogan

On the other side of the world, Argentina's president Mauricio Macri recently traveled to New York to convince Wall Street bond lords that his government was not going to default. Much of the currency weakness there has nothing to do with the dollar, though a strong dollar doesn't help matters.

Earlier this week, Bloomberg reported President Trump complained at a Southhampton fundraiser on Friday that Fed Reserve Chairman Jay Powell was not a “cheap money Fed chair.” The comments served as another reminder to investors that Trump will continue to weigh-in on the Fed’s rate debate until he sees a “Powell pause.” Bostic was ready for a pause. But yesterday's note on the Atlanta Fed's website suggests he has given up on fears that an inverted yield curve will lead to a recession. The economy is simply too strong, Bostic says.

Not too long ago, Bostic could be counted on as a Fed dove, saying he was ready to shatter the “Powell consensus” on further rate increases into 2019. In May, Bostic said, “it is my job to make sure that (an inverted yield curve) doesn’t happen.” He backed up that pledge by saying he “won’t vote for anything that knowingly inverts the curve.” He still favors two more rate hikes for 2018.

Outspoken Minnesota Fed Chief, Neel Kashkari argued against further rate hikes last month.

King dollar may be dethroned sooner than later.

"We do think the dollar had a nice upswing, but we think it's peaked," says Rob Williams, managing director at Sage Advisory, a $13 billion financial advisory firm based in Austin. "The dollar will weaken going into the midterms because of political risk," he says. "The long end of the curve doesn't have a lot of room to go up. We think we are coming to the end of the Fed cycle while other parts of the world are starting to hike and taper. I don't think the Fed will surprise to the aggressive side," says Williams.

Bond spreads between emerging market sovereign debt and the 10 year Treasury are around 350 basis points higher, putting them close to U.S. high yield spreads. That doesn't signal a bear market for fixed income even as currencies in countries like Turkey are getting beat up. Not all of these declines are due to the almighty dollar. Domestic issues are also affecting these currencies. Argentina's peso has recently weakened to over 30 to the dollar. It is back in an IMF program.

"The strong dollar is a headwind if this continues and we are concerned, only less so now than a few months ago," Williams says. They were underweight emerging market stocks and dropped emerging market bonds earlier this year. But due to volatility, the price is right and Sage is back to putting client money in emerging markets.

Two to three more interest rate increases are priced in for this year. Maybe the Fed holds off in December. Any kind of surprise on the dovish side would be a big macro boost to emerging markets.

"The dollar is going to still rally a bit on the hikes even if it is priced in," says Eric Ervin, CEO of RealityShares, a San Diego based ETF company investing in China tech, among other things. "But unless the Fed gets more hawkish, it'll be harder to see the dollar strengthen much more," he says. That will be especially true if the rate hiking cycle ultimately slows the U.S. economy back to an annual growth rate of 2%.

Bostic's comments on the 23th of August didn't frighten global investors. The MSCI Emerging Markets (EEM) ETF rose 1.75% in the first two hours of trading, more than double the gains in the S&P 500.

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9 июля родились
Галим Хусаинов
председатель правления АО «БанкЦентрКредит»
Даулетхан Килыбаев
главный директор по инвестициям Al Falah Capital Partners
Айдын Кульсеитов
заведующий отделом стратегического планирования администрации президента РК
Ричард Эванс
бывший независимый директор АО «Самрук-Қазына»
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