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FUNDAMENTAL ANALYSIS

Central Bank Policy Divergence The Impact of the Dollar

Central Bank, Policy Divergence, The Impact, Dollar, Fundamental Analysis, fx trader, forex

This article covers a somewhat US Dollar centric view, but one that we think is important in understanding how the world works, as there is an obvious policy divergence again between Fed policy and that of all other developed economy central banks, one that should be very supportive of the Dollar in the months ahead.

In a previous article “Oil and dollar dominate thoughts as we wait for Italy to decide” we discussed the concept of how important it is for the US to “export” Dollars to the rest of the world. With a huge amount of global trade still conducted in US Dollars, in order to continuing growing their economies, the rest of the world needs an ever increasing stash of Dollars. In that report, we showed Chart 1 (courtesy of MI2 Partners) to illustrate how the US current account deficit was effectively the source of Dollars prior to the crisis. The chart also illustrates how the Fed’s balance sheet expansion helped bridge the gap when the US current account deficit failed to increase during the post crisis recovery.

Central Bank, Policy Divergence, The Impact, Dollar, Fundamental Analysis, fx trader, forex chart 1

Chart 1 - US Current Account and Global GDP

We have been thinking about this broad subject a lot since then, and the recent output from central bank meetings gives an opportunity to update some of our thinking. Recently, the ECB tinkered with its stimulus programme. As we all know, they extended their QE programme from March 2017 to December 2017, but at a rate of EUR60 billion per month (down from EUR80 billion). Draghi was relatively dovish and hinted strongly that QE would continue into 2018, albeit at a rate to be determined at or nearer the end of next year. Overall, it is a tapering of monthly purchases, however, the pedal is still firmly pressed to the floor.

Onto the US Federal Reserve, where a second rate rise in 12 months was widely expected last week, and they did not disappoint. Frankly, we were somewhat concerned about being aggressively bullish on the US Dollar into the Fed meeting, as the last two years’ worth of meetings had been a series of policy disappointments followed by dovish diatribes from chair Yellen. In the event, the Fed’s forecasts and the Yellen commentary were on the hawkish side, and we quickly had to buy Dollars again. But short term trading aside, there is an obvious policy divergence again between Fed policy and that of all other developed economy central banks, one that should be very supportive of the Dollar in the months ahead.

The significance is that not only does the Fed supply the world with Dollars via QE but it also controls the price of those Dollars directly via interest rates and indirectly insofar as their policies strengthen or weaken the Dollar. As we have explained before, with offshore Dollar debt having increased from roughly US$6 trillion to US$10 trillion in the post crisis period (a huge slug of that being Chinese borrowers), a strong Dollar alone makes servicing this debt more expensive. A strong Dollar combined with rising rates is a double whammy to both US$ borrowers in the offshore world and also those that need to finance trade in Dollars.

Chart 2 is similar to chart 1 except we have taken out the Fed’s balance sheet, and inserted a measure for Global FX Reserves and also the Broad Trade Weighted Dollar. As can be seen, in the years before the economic and financial crisis in 2008, global FX Reserves rose alongside the Global economy whilst the US Dollar weakened and the US’ current account deficit grew (both the Dollar and current account are inverted in this chart). Between 2009 and 2011, the US Dollar remained weak as Fed policy remained very accommodative and before the European crisis erupted; the 2009 to 2011 was the period of fastest economic growth. Post 2011, with a strong Dollar, slower growth in global FX reserves and a broadly static US current account deficit, global economic growth measured in US Dollars has struggled to gain any real momentum, actually declining in 2015.

Central Bank, Policy Divergence, The Impact, Dollar, Fundamental Analysis, fx trader, forex chart 2

Chart 2 - The Global Economy with US current account, US Dollar and Global FX Reserves

Certainly, a strong Dollar and static current account deficit has acted as a bit of a headwind to global growth since 2012. But what of Global FX Reserves? The usual mechanism of reserve accumulation is that a country’s monetary authority intervenes to buy US Dollars and prints local currency to pay for this intervention (this is a bit simplistic, but serves as an illustration). By printing local currency, the non US monetary authorities increase their domestic money supply, which is of course stimulus.

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