The US Dollar index is up 8.6% since the beginning of July and it seems everyone is jumping on the King Dollar bandwagon. With Mario Draghi openly rooting for a weaker Euro and Abenomics pushing down the Yen the dollar has emerged, as it often does, as the safe haven for global investors. The rise could have some major implications, assuming it continues rising, some of which are quite positive and some of which could pose some difficulties, at least short term. One thing that should be noted at the outset is that this isn’t just a case of the dollar rising against a few of its major counterparts like the Euro and the Yen. The dollar is up almost across the board; the Canadian $, the Aussie $, the Pound and the Brazilian Real are all down over the same period, some more (Real) and some less (C$) but all in the same direction. The dollar is also up against gold and the commodity indexes.

What’s behind the move? Currencies usually move based on growth expectations and interest rate differentials. I tend to think growth expectations have a greater influence but that isn’t always the case. Certainly there has been a lot of talk recently about an acceleration in US growth but the bond market refuses to join the chorus and I’m a bit skeptical of any surge. Last week’s data was a near perfect encapsulation of the so-so nature of the data I’ve been seeing for well over a year. There were some good reports with personal income & spending up nicely, the ISM reports pretty good (although less than expected), jobless claims still below 300k and a payrolls headline that certainly looked good. But there were offsetting negatives: pending home sales were down along with mortgage applications, construction spending slipped, factory orders ex-transportation were down again (albeit a meager 0.1%), auto sales slumped from a big August, the trade report showed both exports and imports barely changed and for some reason consumer confidence took a nosedive.

As for that employment report, while the headline of 248k jobs was better than expected the details were once again pretty mixed. Average hourly earnings were down slightly while the workweek edged up just 0.1 hour. The unemployment rate dropped to a cycle low but again due to a fall in the participation rate. The quality of jobs didn’t improve with low paying service jobs dominating the totals. In short, not much has changed.

The bond market doesn’t show a rise in growth expectations; in fact the 10 year Treasury was barely changed on the employment report and the 30 year was actually up slightly in price (down in yield). So it would not seem that growth expectations have changed much in the US but of course with currencies this is a relative game and it is outside the US where growth expectations are falling fast and impacting the currency markets. Europe’s only hope seems to be that a cheaper Euro will accomplish what their politicians can’t or won’t – real structural changes. Hey, real structural changes are hard; currency devaluation is relatively easy but I think the Eurocrats will discover not nearly as effective as actually making their economies attractive to business and work.

The rest of the world doesn’t appear to be in much better shape. China is still slowing and the fears over the potential for an accident as their real estate market deflates remain. That would explain the drop in the A$ and C$ as well as the Brazilian Real although Brazil’s problems would appear a lot deeper than just a drop in iron ore prices. Interestingly, the one currency that doesn’t appear vulnerable – or at least not yet – to the dollar strength is the Chinese Yuan which continues to recover from the selloff earlier this year. There are some bright spots in Asia but in general growth expectations are muted. And of course the Hong Kong gatherings aren’t helping confidence a bit.

Meanwhile, despite the rising dollar pushing down inflation expectations in the US, market participants seem to still believe the Fed will be hiking rates next year. How much and how fast is up for debate but everyone, including the members of the Fed, see this as fait accompli. I have my doubts for several reasons, not least those inflation expectations, but the fact is that the market is anticipating higher rates in the US versus the rest of the world.

So the rise in the dollar is a combination of rising rate expectations (that I think are overblown) and a change in relative growth expectations. In other words, it isn’t that the US is seen as a great place to invest, driving capital here but rather that the US is seen as the least bad, the tallest midget (that’s probably not politically correct), the cleanest dirty shirt. That doesn’t mean that a rising dollar won’t solve some of that problem. Indeed most of the lousy economy we have seen over the last decade in the US can be lain directly at the feet of the weak dollar policies of two consecutive Presidents. And reversing that policy, if it is encouraged and sustained, would go a long way to solving the so called global imbalances that so many have tried unsuccessfully to explain.

The positive global economic case for the rising dollar is fairly simple. A stronger dollar will cap inflation, keep the Fed on hold, increase US purchasing power driving higher imports which will allow the export oriented economies to reaccelerate. Kumbaya and all is well with the world. Over a long period of time that all might come true (and there are other benefits from a stronger dollar) but there are some complications. When the Fed cut rates to zero in the US there wasn’t much stimulus within the US as we were already sated by debt, but the impact outside the US was more profound. Capital flowed to the emerging market economies, especially those that benefitted from higher commodity prices driven by the falling dollar. That created a credit boom from Brazil to Kuala Lumpur. Asia ex-Japan added over $2 trillion in US dollar denominated debt in the last few years and a higher dollar isn’t going to make those debts easier to pay off. Especially if that money was spent to expand natural resource projects (mines, etc.) that are now seeing falling demand from China and falling dollar prices. And now with the dollar rising and growth weakening, those capital flows are reversing. Another emerging market/Asian crisis is a distinct possibility.

Another problem with the stronger dollar is the negative effect it will have on the US oil industry if it continues. Oil prices have been dropping, partly due to the rising dollar (money illusion) and partly due to a supply glut and weakening demand. Regardless of why prices are falling the great expansion in US oil production will be threatened if prices fall much further. No one really knows at what price the fracking companies will have problems but I hear that $85, which is only a few dollars away, is a good starting point. The problem, of course, is that a great deal of debt has been taken on to drill and frack these new wells and high prices are needed to service the debt. A secondary but not minor problem is that a good deal of the growth we’ve had over the last few years, weak as it was, was driven by the oil industry. As I’ve pointed out before, over half the employment gains since the recession came in just a handful of states where fracking has had a major impact. Personally, I’d see a stronger dollar and less oil drilling in the US as a long term positive but the short term, the transition, may be a different story.

As an aside, I am struck by the winners and losers from lower oil prices. In a way, outside the US, lower oil prices hurt all the right folks (and of course are a boon for the average American who isn’t working in the oil industry). Putin and Russia, Iran and ISIS would all feel the pressure of lower prices. It would reduce the likelihood of Russia cutting off Europe’s natural gas supply for sure. Is it mere coincidence that Saudi Arabia doesn’t appear to be cutting production even as prices fall? Is this merely asymmetric warfare on the part of the US and its middle eastern ally? The Saudis would gain a lot if prices can be driven lower. Their enemies in Iran are weakened and the other members of OPEC will learn that they can’t count on the Saudis to take the hit every time prices fall. And if prices fall far enough, killing the fracking industry in the US, the Saudis would regain a measure of control over supply that they haven’t had in some time. Is the administration willing to sacrifice the fracking industry – which their environmental supporters don’t like anyway – as a trade off to punish Putin, the mullahs and the new caliphate? Just wondering.

The recent volatility we’ve seen in the US stock market is a function of the uncertainty produced by the rising dollar. There are certainly long term positives but the short term negatives may be the main focus for now. We might even start to see some of that negative impact in the soon to start earnings season. Over 40% of S&P 500 revenues come from outside the US and unless those companies are hedged properly and completely there will be some impact on revenues and earnings in the just completed quarter. More than that, it might show up in companies projections for future quarters and then get reflected in earnings estimates that are already showing pretty meager growth expectations.

One last thought is that the recent rise in the dollar is the most rapid since, yes, 2008. Back then it was driven by liquidity issues and there is certainly the possibility that is once again part of the equation. A rapidly rising dollar may well be as much a sign of stress somewhere in the global financial system as anything else. For now, I’ll take the more conventional explanation but don’t be surprised if some black swan paddles across your screen sometime soon. What’s up with the rising dollar? Volatility and you should expect more.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.