The Dollar Wrecking Ball Decapitates Sterling

We didn’t need to try and head it

Breaking Things

Having warned about scary forward indicators for a while doesn’t make the reality of market breakages in the British pound, UK government debt and mortgages any more palatable. But while we are fixated on the UK circular firing squad of our government’s political and financial incompetence, be in no doubt that the underlying issue the world is dealing with emanates from its dollar trading system. The UK is playing the game on the same upward-sloping football pitch as every economy outside North America. We are just more adept at scoring own goals.

Wrecking Ball

The financial deterioration we face is due to an unprecedented pace of monetary tightening. The epicentre of this tightening is the US, and its transmission is via its reserve status. The US dollar has become the world’s financial wrecking ball. First in line were vulnerable emerging economies with dollar debt, such as Sri Lanka. But the mighty dollar is now crashing through the more established economies of Japan and Europe and the Asian powerhouses of India and China.

Not Our Problem

As this tightening progresses, there are fewer hiding places. Fed pivot watchers await evidence that things are breaking sufficiently for the FOMC to ease off and for conditions to improve. They (well, I must be honest here, we) believed it was on its way in the Summer, before Jackson Hole. But the things that have broken so far are of no concern to the US Federal Reserve. (The clue is in the name).

What Crisis?

Fed Chair Powell and his political masters don’t see a recession, as evidenced by the 1.7m new jobs created in the past four months, according to the US non-farm payroll data and the stubbornly high measures of consumer inflation. Only yesterday, Treasury Secretary Yellen said: “We haven’t seen liquidity problems develop in markets [and] we’re not seeing, to the best of my knowledge, the kind of deleveraging that could signify some financial stability risks”. Well, dammit, Janet, the Bank of England certainly did.

Big Mac Rule

The dollar wrecking ball era will be finite, but it isn’t ending yet. After Paul Volcker famously defeated inflation of the 1970s, the dollar appreciated sharply against other major currencies (with most Latin American and sub-Saharan African economies serving as collateral damage). Eventually, the Economist’s Big Mac index holds sway. Currencies trend back towards their long-term purchasing parity, and ultimately the US economy will suffer the consequences of an overvalued currency.

But Don't Hold Your Breath

In the 1980s, though, it took five years of compounding dollar strength for US manufacturing to be crushed by Japanese imports. The US called a meeting of the world’s largest economies at the Plaza Hotel in New York in 1985. What became known as the Plaza Accord was a coordinated attempt to reset the global terms of trade. (While this policy succeeded in its primary objective to reverse dollar strength, its unintended consequence of creating Japan’s financial bubble, the first of the modern era, was probably more consequential).

The British Way

Meanwhile, back in Westminster last week, within days of showing the world how to organise constitutional affairs of state and royal protocol, the executive branch of the UK government demonstrated a complete competence failure. In short, the new government needlessly worsened a bad financial situation.

Guidance Needed

Much of what Kwasi and Liz want to do makes economic sense. The productive capacity of our economy needs improvement, particularly the need to increase energy supply. But all long-term investment projects need to be credibly costed and financed. Furthermore, as any PLC finance director knows, the project’s investors require guidance and don’t like surprises. All this is particularly true in times of heightened uncertainty and volatility. Unsurprisingly gilt investors puked at what they heard.

Politically Weak

Politically this is the last roll of the dice of a late cycle government that has chosen to vacate the central ground of British politics. Not only do Kwasi and Liz not have an electoral mandate for their policies, but on many of them, they will face opposition from their own MPs, most of whom favoured a more cautious candidate as their leader. Investors are not stupid; they know weakness and lack of credibility when they see it.

Pension Pain

Within days of the UK’s fiscal own goal, the Bank of England has stepped in with a trifling £65bn of temporary measures to defend the UK government bond market and drop its quantitative tightening plans to restore financial market stability. The pain point was the solvency of the nation’s sacred final salary pension funds, which are all required to own large amounts of long-dated government debt in the drive for “ultra-safe” Liability Driven Investment, or LDI strategies. (I know, I have questions too).

Next to Quack

But we all know that there is nothing more permanent than a temporary government measure, and while there is no mention of a return to QE, if it waddles and quacks, we all know what it is. As the dollar wrecking ball swung, the UK lifted its head, and its bond market was de-capitated. All non-dollar currency blocks’ have limits to tightening their monetary conditions. The UK now knows its limit, and after the recent Italian election delivers its first non-EU-appointed finance chief in a decade, the Eurozone is probably next in line to test its limit. The ECB transmission mechanism will appear duck-like to gobble up Italian debt without mention of its QE doppelganger. But investors will know it when they see it.

And Breathe

The bad news for those outside America is that the US economy can run for a while before it hits the pain point the rest of us have already reached. Eventually, the only thing left in the dollar wrecking ball’s path will be the US economy. As the bumper sticker somewhere in the Mid-West must say, The Fed Wants You To Lose Your Job. That is the point when Janet Yellen and Jay Powell wake up. The pivot happens, and we can all breathe again

The post The Dollar Wrecking Ball Decapitates Sterling appeared first on Progressive.