Your currency, our problem

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The development of the US dollar is highly relevant to the direction of financial markets. Whether the world likes it or not, the world does depend on the US dollar. The only one that can print additional dollars is the US Federal Reserve. This effectively makes the Fed the world’s central bank. Since March 2021, the growth of dollar liquidity has been declining (i.e. the second derivative), as can also be seen from the development of the M2 money supply in the United States. The peak in M2 coincided with the peak in more speculative assets such as cryptocurrencies, SPACs, IPOs, and shares of companies that do not make profits but were highly valued. Now, money supply growth is at a point where in the past there was usually a significant financial crash. Developments in the UK are also related to shrinking dollar liquidity. While it seemed that the impact on sterling and interest rates was a direct result of Trussonomics, it was mainly the limited liquidity in the global financial system that caused the big outcomes.

There are several reasons why liquidity growth in the United States is slowing down. The central bank is raising interest rates and shrinking its balance sheet. Higher oil prices are also reducing dollar liquidity. Nearly 100 million barrels a day are consumed daily, and given the many weeks’ oil is on the road, this quickly adds up to a large amount. Moreover, inflation is not limited to oil; other dollar-denominated goods are also rising in price and thus require more liquidity. What may also play a role in the dollar’s strengthening is that other countries (read central bankers) are no longer willing to finance the US budget deficit. Using the dollar as a weapon after the Russian invasion of Ukraine, few Russians will buy US treasuries anymore. Since the Arabs and the Chinese could happen to do the same thing at any moment, they are also no longer keen on financing the US budget deficit. At the same time, though, the US government is looking for more financiers, so they have to come from the US. The sizeable US national debt does need to be financed. This is not the first time a currency has strengthened precisely when there is actually a crisis. The yen rose sharply between 1990 and 1995 when fundamentally the currency should have come under pressure. The euro also rose sharply in the run-up to the euro crisis. The high dollar does start to pose a problem for US corporate profits. Usually, currencies are hedged by companies some time in advance, so gradually the pain for US businesses is starting to get bigger. For US investors, the pain is also great this year. We have to go back to the 1920s to find a year when the ‘neutral’ portfolio has done even worse. That also creates additional demand for dollars. Now it is liquidity problems in the UK government bond market, the US bond market is many times bigger.

The liquidity squeeze has reached a point where it is causing financial crashes. In the past, the Fed would then respond with additional liquidity, something financial markets clearly benefit from. The difference with the past, however, is that policymakers then faced deflation risks and now the problem is inflation. Eventually, even the Fed will have no choice but to conclude that the current dollar market is too tight and possibly, as, in the UK, there will be new forms of quantitative easing in the US, the well-known twist in monetary policy that the whole market is looking forward to.

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