In the extreme chaos of Donald Trump’s presidency, an event five months ago can feel like five years ago. Case in point: the US president ending the strong dollar policy.
On Jan. 24, Treasury Secretary Steven Mnuchin did just that, sending the US currency reeling and Asian blood pressures surging. It didn’t work, though. In fact, the dollar just had the best three-month run of the Trump era. Are we on the cusp of the dollar rally bulls have been predicting?
Perhaps, as the divergence between Federal Reserve policies and the rest of the globe widens. US data are solid, suggesting America’s heavy lifting in the years after the 2008 global crisis is paying off. The Republican Party’s $1.5 trillion tax cut added more fuel – fuel that an economy near full employment didn’t need.
Data elsewhere are softening. Europe, Japan and even China are losing altitude, reducing the odds of interest rate hikes anytime soon. The Jerome Powell Fed, by contrast, may be more aggressive than markets believe as top-line growth gives him greater justification to normalize rates.
That should put Asia on edge. While a dollar devaluation worries export-led economies, a surge poses another threat: bringing back traumatic memories of 1997, when dollar-denominated debt became too expensive to repay.
Fears that the Fed might overtighten, knocking Asia off balance, dominated 2013. That was under Powell’s predecessor Janet Yellen. The mere specter of the most powerful monetary authority tapping the brakes savaged emerging markets. Morgan Stanley’s “fragile five” list at the time included India and Indonesia along with Brazil, South Africa and Turkey.
Then-Fed Chair Yellen managed to hike interest rates in December 2015, the first tightening in nine years. Powell has since picked up the pace, boosting the benchmark to 2%. That pushed the 10-year Treasury yield toward 3%, putting upward pressure in the dollar. The DXY index based on a basket of global peers jumped 5.2% in the last three months.
That gets us back to 1997. The trouble began in 1994, when the Alan Greenspan Fed began an epic tightening cycle that has traders wondering about the Powell Fed’s plans. Beginning that year, the Fed doubled short-term rates over a 12-month period. The ferocity of the cycle bankrupted Orange County, California, killed securities powerhouse Kidder Peabody and thrust Mexico into crisis.
It also set the stage for Asia’s collapse over the next three years. Dollar pegs became impossible for Thailand, Indonesia and South Korea to defend. Corporate loans denominated in dollars became impossible to service. Devaluations, defaults and panic sent contagion around the globe.
There are myriad reasons why a repeat of 1997 isn’t likely. Currencies are of the floating variety today. Stockpiles of foreign-exchange reserves have been amassed. Financial systems are stronger, governments more transparent, central banks more independent, economic growth engines more diverse and middle-class consumer sectors more stable.
The bad news: emerging-market debt has quadrupled since 2008, a state of affairs that worries economists from Harvard University’s Carmen Reinhart to Nobel laureate Paul Krugman.
It hardly helps that China, an unbalanced emerging economy, is now Asia’s main growth engine. Or that Trump’s trade war is actively throwing China off its game. A surging dollar could lead to a spate of Chinese defaults that shake world markets. Count Reserve Bank of India Governor Urjit Patel among those losing sleep over the Fed overdoing it.
The dollar’s upward trajectory is a huge wild card for the second half of 2018. It could be a head-fake, of course. Trump might double-down on his weak-dollar policy. Who knows, he might even start attacking the Powell Fed on Twitter. But the greenback’s brawn suggests Asia’s troubles have only just begun.