A Different Kind of Dollar Demand

THE DANGEROUS SPARK - Every so often, a story will hit the markets out of nowhere and generate so much attention, that it ends up becoming everything. This is what we've seen in markets over the past few days and this is what has been at the source of much of the anxiety and stress that has resulted in an acceleration of an already bid US Dollar. When these stories hit, the market starts hearing about contagion and systemic risk associated with the story, which means fear that whatever fallout is going on out there, will spread and infect the rest of the global economy. So what's been going on out there that has been the source of all of this? Well...have you seen the Turkish Lira?

THE SOURCE - The Turkish Lira has been in collapse mode and the setbacks in the currency have been so frightening, that they have finally started to make waves into the rest of the market. Into 2018, the Lira had already been under great pressure and was trading at record lows against the US Dollar. Fundamentally, the cause for all of this stems from the fact that Turkey is one of those rare major emerging market economies that runs a trade deficit. Most emerging market economies run a surplus, which means they are shipping out more than they are consuming. In these scenarios, these emerging market economies are built to benefit from a weaker currency because it makes it more attractive to buy products from these economies. But in the case of Turkey, where the country is less export driven, a falling currency can be a nightmare. The only other emerging market of note that runs a deficit Argentina and unsurprisingly, the Peso has been crushed as well.

THE ADDED STRAIN - The politics of it all is where things have gotten even more contentious. Turkey's President, Tayyip Erdogan, has been staunchly opposed to policy tightening as a means of offsetting downside in the Lira. As we know, when you move rates higher, it attracts capital, which in turn effectuates a move up in a currency. But Erdogan doesn't want his central bank to tighten policy as he does not want the higher rates to burden the domestic economy. While higher rates attract capital, they also make it much harder for locals to be able to borrow and spend. So it becomes a big trade off. The trouble is, when your currency is sinking at alarming rates, sticking to your guns can be a costly exercise. Throw in a reluctance to make such adjustments to policy with the added strain of tension between the US and Turkey, which is where we are at (See this Washington Post article for more detail).

THE RIPPLES - So why the spread to the rest of the market? Well, like with most things, there are investors and these investors have exposure to the crisis that puts these investors in a more vulnerable position. So when the ECB cites a number of European banks that have exposure to the Turkish Lira, which means big losses on their books from the setbacks in the currency, those losses can result in big time problems for those banks that threaten there very own ability to operate. And so, the ripple effect plays out and we get more fear and panic spreading beyond the source, which then transforms into a bigger flight to safety play and exodus from all risk assets, with emerging markets getting hit hard across the board. So this is where we are at and this is what has been going on. It's important that all of this is clear as all of this latest appreciation in the Buck has come from something different than what had been driving the Dollar's appreciation in 2018. It's important because the market should be careful to not get overly comfortable long the US Dollar. When things settle down in Turkey, which I imagine they will, we will once again be getting back to the story of soft Dollar policy out of the US administration and a battle that I don't believe it has any interest in losing.

THE DOLLAR - There are two big reasons the US Dollar getting stronger is not in the interest of the global economy. The first I have spoken about at great length. The first reason is the fact that a stronger Dollar encourages things to move along as they have been in the US, which means a gargantuan deficit that continues to grow towards a much bigger crisis. Weakening the US Dollar means getting the US economy to a place where it is more competitive on the export side and consuming less, which means a reduction in the deficit. The second reason the market should avoid encouraging a stronger Dollar is because a stronger Dollar puts a massive strain on emerging markets and a massive strain on emerging markets could result in a blowup that devastates the global economy. There is a point at which an export economy is no longer attractive, even if the product becomes cheaper. This is because the emerging market currency is falling at such a drastic rate, it becomes impossible to be doing business, as it becomes more expensive in a local currency to purchase dollar-based commodities and debt. This second point should be considered more seriously as well. So overall and on net, as I have been arguing, better the US Dollar weaken from here at a steady clip, than the Dollar appreciating out of control.