A global macro investor needs to understand all asset classes: currencies, commodities, equities, bonds and real estate. In my first article, I introduced the concept of global macro, and in my second article, I started on currencies with particular focus on the dollar. In this article, I will elaborate further on currencies and end with why the dollar is the most important thing to watch in 2015.
Since the 1980s, the dollar has had a steady half-century as a world reserve currency. The dollar did depreciate against the Swiss Franc (CHF), the Japanese Yen (JPY) and for a short period, the Euro (EUR) as well. But there was no threat to its reserve currency status. It is still the most widely held currency, and the market for US treasury securities (a fancy name for the IOUs of the US govt) is still the deepest and most liquid market in the world.
This phase (of dollar stability) ended abruptly in 2008, when the Federal Reserve announced Quantitative Easing, whereby they would pump in hundreds of billions of new dollars into the economy. According to investors’ simplistic view of the world, such massive money printing by the central bank would surely cause inflation, leading the dollar to lose value rapidly. This had already happened once in the 1970s, when the dollar was de-linked from gold and lost value for a whole decade. With interest rates on the dollar close to zero percent, and the Fed determined to print more and more, investors lost confidence in the dollar. Institutions which were long the dollar began to sit up and take notice (going long means profiting from the rise in value of that asset). Traders took advantage of the cheap dollar to borrow in dollars and invest in emerging economies, a phenomenon called a ‘carry trade’.
And here, we take a pause (for no cause) from the dollar story to understand how this affected other countries.
1997 Asian Financial Crisis
In the 1990s, someone in the Wall Street community decided that Asia is booming and is worth investing in. Young hotshots with dollar signs in their eyes flew into Seoul, Hong Kong, Djakarta, Kuala Lampur, Bangkok, Singapore etc. and decided to pour money into the upcoming Asian miracle. And it was a miracle – all these countries got free money. The market let them increase their dollar debt. Capital inflows increased every year, so repayment was never an issue. The debtors could simply borrow new money to repay the interest and principal on their maturing debt. With exchange rates fixed to the dollar, both lenders and borrowers did not worry about currency risk. The scheme continued, and everybody got rich, until the market finally realised that these loans would never be paid back. All of a sudden, everyone wanted their dollars back. Nobody wanted the worthless Thai Baht or Malaysian Ringgit or Indonesian Rupiah. Traders who had borrowed dollars to invest in these Asian miracle economies lost a bundle as the dollar surged and their investments in local currencies went sour.
In 1997, the US dollar carry trade unwound and wreaked havoc on the Asian economies.
The $9 TRILLION Carry Trade
Since 2008, investors have been borrowing in US dollars and investing in emerging economies. By some estimates, the carry trade has now grown to over $9 trillion dollars. To put that into perspective, world GDP is $77 trillion. The bad news for the rest of the world is that the US dollar is now strengthening.
The US Dollar Index (DXY) measures the strength of the dollar against a basket of major currencies. It currently shows the dollar at a consolidation phase before it decisively resumes its trend higher. That would be the death knell for the carry trade, and it is the single most important economic indicator for 2015.
Like in the 1997 Asian Financial Crisis, currency moves can rapidly trigger economic recessions in countries which have so far been buoyed by US dollar inflows. Just like in 1997, it is the emerging economies which are particularly vulnerable, especially ones with a large current account deficit and dollar denominated debt.