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The (Big) Problem with a Stronger Dollar

The (Big) Problem with a Stronger Dollar

Kathy Lien, Technical Strategist

The Fed-inspired US dollar rally has caused tremendous volatility across the world’s financial markets, and virtually nothing, from equities to commodities to currencies, was safe from massive price swings.

The US dollar (USD) continued to power higher against all major currencies, wreaking havoc across the financial markets in the process. While we can't blame all of the volatility on the dollar since ten-year US Treasury yields also spiked above 2.4%, the latest moves have unsettled investors around the world.

Consequently, the S&P 500 dropped 2.59%, European equities fell 3%, and major indices in Asia lost anywhere between 1.5% and 3%. Most of this weakness can be attributed to the spike in global bond yields, which boosted the cost of borrowing around the world. This accelerated deleveraging in the forex market, and dollar strength only added to the pain.

See also: A “Major Turning Point” for the Dollar

The rally in the US dollar has driven the Australian dollar (AUD) to a fresh 2.5-year low and the New Zealand dollar (NZD) to a one-year low, but the biggest moves were in commodities. Gold prices fell more than 5% and silver prices a whopping 8%. These are the lowest levels seen in both commodities since September 2010. Even oil prices fell 2.9% and closed near $95 a barrel.

While the world may wind up thanking the Federal Reserve for keeping inflation at bay and boosting the US export sector by weakening the currency, right now the focus is on volatility and its impact on confidence.

Central banks around the world are not going to be happy with the pace of depreciation in their respective currencies, as well as the spike in bond yields and decline in stocks. Unfortunately, given the amount of re-pricing that needs to occur, the latest moves could extend further.

However, the selloff in US stocks and the panic across global markets are not completely justified.

Investors should realize that the Federal Reserve is planning to reduce asset purchases due to increased confidence in the US economy. The latest upside surprises in the Philadelphia Fed survey and existing home sales only supports that decision.

The central bank would not be taking steps that will drive Treasury yields higher if policymakers did not feel that the US economy and corporations could handle it. So eventually, the selloff in US stocks should stabilize, allowing US yields and the dollar to hold on to their gains and grind slowly higher.

Big Problems Brewing in China, Too

Meanwhile, the "cash crunch" in China has only made investors more nervous. Interbank overnight lending rates in China spiked to a record high of 13.44%, up from 7.66% the previous day!

One month ago, the rate that banks used to borrow from each other was less than 4%. The rise in the interbank rate began two weeks ago before a three-day holiday when demand for cash increased and rates followed.

In the past, the central bank would inject money into the system to offset demand, but when they refrained from doing so, rates started to climb higher, and the situation was made worse by weakening economic data.

Now China finds itself in a liquidity crunch and begging for the central bank to step in. Unfortunately the People’s Bank of China (PBoC) refuses to do so because it wants to punish speculators and is in the midst of reforming the economy. The longer the banks hold off, however, the more disruption it will have on China's economy and the global financial markets.

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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