Currency War

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We have entered an all-out currency war. The most publicized salvo came 2 weeks ago from European Central Bank (ECB) President Mario Draghi when he announced the ECB’s quantitative easing package of over $1 trillion euros.

The ECB announced an open-ended bond-buying program of 60 billion euros ($70 billion) a month in an effort to fight off the prospect of outright deflation. (The region’s inflation rate was a negative .6% in January). After the ECB bombshell, the dollar index surged to its highest level in a decade while the euro plunged to 1.11 - an 11-year low.

Even before the ECB move, surprise policy changes were announced by Denmark, India, Canada and Switzerland. Last week, we saw Singapore, New Zealand and Hungary central banks push their currencies lower. (Even Russian lowered its interest rate by 2 basis points, after hiking it to 17% in December in an attempt to support its collapsing ruble.) This week, India (again), Australia and China joined the parade of central bankers taking steps to bolster their economies.

The U.S. dollar has been the beneficiary of those moves by central bankers and their easy policies. In 2015 alone, the dollar has strengthened nearly 7% against the euro, more than 7% against the Canadian dollar and 6% against the New Zealand dollar.

Over the past 12 months, the moves are in the double digits with the dollar strengthening more than 20% against Sweden's and Norway's currencies, 17% against the euro and 13% against the yen.

By weakening their currencies (15 countries have already done so in 2015), central bankers around the world are by default strengthening our dollar. If the Federal Reserve raises interest rates this summer, as is generally expected, it will only strengthen our dollar even more.

In contrast to other central banks, our Federal Reserve is not making any moves or talking down its currency. It is interesting that the rhetoric at the Fed has shifted from talking about unemployment to talking about the weakening inflation picture. The rising dollar could become a problem for the Fed. As a rule of thumb, for every 10% increase in the dollar, inflation falls by 0.5%. Since CPI in the U.S. is at 1.7%, a stronger dollar could become a headache for the Fed.

With the Fed appearing to give its blessing to dollar buying, which central banks could hit next? Economists are watching South Africa, Mexico, Korea, Philippines, Poland and Taiwan as countries that could make a move next. In other words, cuts are contagious. Rate cuts weaken currencies. In a growth-starved global economy, no country wants to be on the other side of that trade with a strong currency.

Why is the dollar rising?

In addition to the moves by central bankers, the stronger U.S. dollar is due to a combination of factors: relative interest rates, balance of trade, and perceived safe-haven status. Several key factors, including an improving U.S. economy and sluggish growth in Europe and Asia, are pushing the dollar higher. A stronger U.S. economy is expected to spur the Fed to increase interest rates later in 2015. With interest rates likely to be higher in the U.S. than in the Eurozone, Japan and China, investors will move more capital to the U.S., further supporting the dollar. In addition, rising U.S. energy independence has reduced the amount of oil imported from overseas, which has helped shrink America’s current account deficit. In theory, a lower U.S. current account deficit reduces the global supply of dollars and raises the price.

A strong dollar can have profound ripple effects in 3 major areas:

1. Global commodities. The price of oil, gold, wheat, corn, soybeans and nearly every commodity bought and sold in the global market is priced in dollars. Foreign buyers will purchase our commodities – corn, soybeans, wheat, oil, etc. – with dollars. When the value of the dollar drops, they will have more buying power and simple economics tells us that demand typically increases as prices drop.

On the other hand, as our currency gets stronger, it makes our goods more expensive for foreign buyers. We export roughly 20% of our U.S. agricultural production to other countries, according to the USDA. As our dollar strengthens, we become less competitive against international producers. This could be the theme for the rest of the year and possibly longer.

The currency war increases competition for U.S. grains, particularly for wheat. World buyers are now going to Western Europe to make purchases as the weaker euro provides a much cheaper value than U.S. wheat. After the 15% depreciation of the euro, importers are buying wheat in weak euros from Europe at what amounts to about a 75-cent discount to buying wheat from the U.S. in strong dollars.

As you know, our grains and soybeans have been heading south in 2015. Hardest hit has been wheat - down 18% in January. The runaway U.S. dollar impeded the ability of American grain exports to remain competitive with strong production from countries with weakening currencies such as Russia, Europe, Australia and Argentina.

You saw what the collapsing Russian ruble did for their wheat exports this year. Russia sold and shipped more than 80% of their wheat exports for the marketing year by the end of December because their depreciated currency made their wheat the cheapest.

That’s why our share of the world wheat trade this year has shrunk to 16% of the global wheat trade, which is the lowest percentage since the data began in 1960, according to the USDA. This contrasts with the peak in U.S. wheat exports in 2007-2008 when they reached 34 million tons and comprised nearly 30% of world wheat exports. Giving a boost to our wheat exports 7 years ago was a 30% decline in the value of the dollar from 2002. The tables were reversed then and the dollar's fall in value reduced the price for U.S. wheat compared to wheat produced by other countries.

Soybean exports have not yet suffered from the effect of the strong dollar as soybean exports are expected to be 7.5% larger than last year. Although it has been reported that China has been cancelling U.S. soybean orders during the last 3 weeks in favor of cheaper soybeans from South America, this is probably more about Chinese buyers taking advantage of South American harvest prices than the strong dollar. Our dollar has appreciated only about 3% against the yuan during the past year.

After energies, soybeans and wheat are most correlated to dollar.

Jodie Gunzberg, global head of commodities at S&P Dow Jones Indices, analyzed how different commodities are correlated to the dollar. (The year in which each individual commodity was introduced is shown in parentheses.)

Commodities typically follow an inverse relationship with the value of the dollar. Negative correlations mean that the values move in opposite directions: The five commodities with the strongest negative relationship to the dollar are all oil-based with the two crude oil benchmarks coming in at the top of the list. Soybeans and wheat follow the energies and lead with the strongest inverse correlation. Meanwhile, livestock and sugar have the weakest correlation with the dollar.

A strong dollar also affects...

2. Multinational companies. The strong U.S. dollar reduces the attractiveness of our goods and services sold overseas. As the dollar strengthens, U.S. companies are either forced to raise foreign prices to maintain margins or accept fewer dollars for their goods. About 40% of the revenues of the S&P 500 companies come from overseas. The stronger the dollar, the weaker their earnings growth. This helps explain why the S&P dropped 3% in January while the dollar rose. A European company that purchases goods from the U.S. must now pay 15% more for the same products. We saw the effect of a strong dollar on multinational companies when they announce disappointing earnings and guidance. In fourth-quarter earnings, companies such as Caterpillar, Pfizer, IBM, DuPont and Procter & Gamble have been negatively affected by the dollar's surge.

3. Emerging economies can be crushed by the strong dollar. In the early 1980s, a bullish U.S. dollar contributed to the Latin American debt crisis, and also impacted the Asian Tiger crisis in the late 1990s. Emerging markets typically have higher growth, but carry much higher risk. When the economies are doing well, foreign investors will lend money to emerging market countries by purchasing their bonds. It becomes especially ugly for emerging market economies that produce commodities. Many emerging market countries rely on their natural resources for growth and haven’t yet developed more advanced industries. As the products of their principal industries decline in value, foreign investors remove available credit while their currency is declining against the U.S. dollar. As a result, they find it difficult to repay their debt.

Looking forward…

Commodities generally did poorly last year as the dollar began to take off. Oversupply, weaker-than-expected demand particularly in China and the strength of the dollar are three key reasons behind much of the decline in commodity prices. Looking forward, a stronger dollar may tend to keep some sort of ceiling on commodity prices. For perspective, the size and length of the latest dollar moves are relatively modest compared with past periods of dollar strength. It is not uncommon for a cycle of appreciation (or depreciation) to last for several years and cause movements of 20% to 30% in the value of the greenback. As one veteran currency observer warned, "This currency war cannot go well. They never have."

Our Treasury Secretary Jacob Lew says a strong dollar is good for the United States. The strong dollar reflects America’s success. It may also be a case of be careful what you wish for.


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