[ihc-hide-content ihc_mb_type="show" ihc_mb_who="14,16,20,23,24" ihc_mb_template="1"] The U.S. Dollar is driving higher and given the underlying backdrop- it’s unlikely to pause its run higher. Whenever the dollar makes a run, it usually spells a lot of problems for the rest of the world because close to 80% of trade transacts in USD or crosses a U.S. bank. The dollar also makes up about 60% (on average) of FX reserves within a country that the central bank will use to protect the local currency. Central Banks/ foreign governments will us reserves to stabilize local currency by purchasing the local float and selling USD into the system. This helps reduce the float of currency and provide some form of protection. Inflation throws a huge kink into that shift as fear causes investors to dump currencies that the local central bank is forced to absorb. This causes reserves to dwindle and without a healthy export market- the CB has to go into the markets (or a Fed swap) to replace the dollars drained. Many foreign governments and corporations issued dollar denominated debt starting in earnest in 2014 to capitalize on USD weakness and a new investment basis looking for yield. A big hinderance of buying foreign debt was the need for interest rate swaps, so the international entities simplified the equation by issuing debt that paid principal and interest in dollars. As the dollar shifts higher, the cost to pay that interest grows exponentially because they have to exchange currency in the open market. If they trade internationally, the company can use the dollar naturally flowing in to cover interest, but as global trade slows- the cost of managing their debt burden expands. Governments are also tasked with purchasing food and energy in the market, which all trade in USD and also drain reserves faster as the dollar rises. Countries have been raising rates to try to get in front of inflation, but as global prices remain elevated- they haven’t been able to curb inflation nearly as much as hoped. The problem is that during COVID19 every government and central bank issued a huge surge of support to boost the economy. This flooded the market with currency and has now led to a global record in rate hikes and global tightening. Just like everyone else, the Fed is in QT mode and that only expands as we head into September. The rise in rates and tightening liquidity is needed to absorb the excess currency around the world, but results in a slowdown in activity and the cost of borrowing moving up- especially in the emerging market world. The G5 have been carrying out some form of QE since 2008, and the world has gotten drunk on cheap debt and a plethora of USD floating around. As that is absorbed, the emerging market world is going to struggle to borrow and pay for their existing debt portfolio. On a global level, we are seeing the economy contract on a sequential basis, but it started in the developed world and takes time to trickle down to the emerging world. As developed markets slow, they slow purchases and orders that take time to move down the supply chain. Manufacturing has held in longer in the Emerging market world but is starting to rollover as the pain grows around the world. They are still in expansion, but over the next few months we see that dipping into contraction. It could happen much faster as the pain expands in Europe, and the whole region drops into a recession faster. PPI is an important leading indicator for inflation because companies come up with their price based on their costs. We have seen costs remain elevated around the world, which will keep prices high around the world and pin global inflation at multi-decade highs. The below are just two examples of important exporting nations especially in Europe that has seen their current accounts flip into contraction. Another hit to international markets is the pivot to “near shoring” or “onshoring” as companies look to address their supply chain. According to Bloomberg transcripts of U.S. companies’ earnings calls & presentations, onshoring/reshoring/nearshoring buzzwords are being thrown around more often than ever this year, exceeding level seen in early days of pandemic. The movements aren’t even across all countries with the biggest hit striking China and Germany. India and Vietnam have benefited from the shift, but the movement of companies out of countries such as China impact their ability to “naturally” source USD. This is why we focus so much on FX reserves- especially as the 10-year treasury moves back above 3%. Typically, foreign debt is priced off of the “risk-free” rate of the US 10 year. So as that moves higher, it increases the cost for emerging markets to borrow as well as issue new debt. As investors become more risk adverse, we see outflows from EM debt and equity. This makes it difficult for countries and foreign entities to access capital markets resulting in the local economies slowing faster. We still believe that the 10-year is heading up to 4%, and between the rise in rates and increase in volatility- the cost to emerging markets is going much higher. It’s very important to remember that Quantitative Tightening in the U.S. is JUST GETTING STARTED! The Fed has barely scratched the surface on tightening and we are already seeing a reverberation throughout the system, which means it only gets worse as we go forward. QT is going to accelerate in September as the bond portfolio (selling) increases as we progress throughout the month. This process will pull even more dollars out of circulation and drive the dollar higher and crimping EMs further. Here are how the dynamics work: when the Fed buys a treasury bill they put new USD into circulation. They are buying the paper and issuing dollars to complete the transaction. Now the process is reversed, they are selling treasuries into the market and pulling USD out of circulation. This is taking more liquidity out of the market, and it will accelerate in September as more paper is sold/ less is purchased. When we look at dollar denominated debt, I just pulled some samples of countries that have bonds denominated in dollars. Here is a look at developing countries non-bank loans denominated in dollars: Here is the total in the world: Dollar denominated debt has only gone straight up around the world with the amount of global debt sitting at record levels. As we have global debt closing out 2021 at $303T, there is a lot of pain ahead as countries pull back on borrowing/spending. The US Dollar strengthening so fast will just accelerate the pain, and we are still at the very beginning of the surge. As the very first chart showed, we are coming into the “Danger Zone” for US dollars rise and we believe the DXY is heading to 115. It’s revving up to make a run at the highs we saw in 2001 and 2002, but as we showed earlier- there is WAY more dollar denominated debt than ever before. This time around- the pain is going to be even bigger vs the ’98 Asian currency crisis. Buckle up because we are in for a bumpy ride! [/ihc-hide-content] [ump-visitor ] To unlock the content you need a Premium or Enterprise Account! [/ump-visitor] [ump-logged-user ] This content is visible only for Enterprise Account! [/ump-logged-user]