The world is more important to America than America is to the world.
 
That observation is not original but has never seemed more apt. This state of affairs has both geopolitical and economic roots. On the former, I have definite opinions, but I can’t say they’re worth more than what’s offered from the next bar stool, and, moreover, I am well aware that they’re not why you’ve parted with the price of this peerless weekly.
 
As for the relevant topic at hand, the U.S. financial markets and economy are subject to global influences to an extent arguably not seen for a century or more. Specifically, the exchange rate of the dollar is affecting securities markets in ways not familiar to most Americans.
 
To be sure, there have been episodes when a weak greenback has caused all sorts of pain, from the stagflation of the 1970s to the stock market crash of October 1987. And the greenback’s slide in the wake of aggressive easing actions by the Federal Reserve following the 2008 financial crisis gave rise to questions of whether it would remain the world’s dominant currency for transactions and as a store of value, along with complaints that the U.S. was cheapening the dollar to gain a trade advantage.
 
Now, we are seeing the flip side. One would think, just as one can’t be too rich or too thin, that one’s currency can’t be too strong. There could be steep costs, as in the 1980s, when the super-muscular greenback largely was the product of double-digit interest rates engineered by the Volcker Fed. That was cured easily and painlessly with rate cuts.
 
Now, however, the Yellen Fed is merely contemplating lifting its interest-rate target from the nearly irreducible 0% to 0.25% that has prevailed since the crisis days of December 2008. (I will leave aside compare-and-contrast questions about the fiscal and regulatory policies of three decades ago and the present.)
 
To make sense of this new world—not necessarily a brave one—we consulted someone with unsurpassed global knowledge and insights: our Barron’s Roundtable veteran, Felix Zulauf, president of Zulauf Asset Management and co-chief investment officer and partner of Vicenda Asset Management in Zug, Switzerland. When I caught up with him last week, he had just gotten back from a five-week excursion to the far reaches of the Southern Hemisphere, including, most spectacularly, Antarctica. Despite having been so recently at the ends of the earth, Felix had his sights set firmly on the global situation.
 
When the Roundtable gathered in January, he perceived that the dollar would be rising in what he termed a global short-covering rally. To explain, the Fed’s massive quantitative easing resulted in even more massive borrowing abroad of the dollars the U.S. central bank had created. That observation was corroborated in a report by the Bank of International Settlements, the putative central bank for central banks, that non-U.S. borrowers had increased their dollar indebtedness by some 50% since the financial crisis, to $9 trillion from $6 trillion.
 
Following this credit boom outside of the U.S., the Fed ended QE and is contemplating its first interest-rate hike. And as the Bank of Japan and the European Central Bank are engaging in their own quantitative easing, pushing the greenback higher against the yen and euro, these dollar debtors are getting pressured by the prospect of having to pay back their loans in dearer dollars. In trading parlance, it’s a classic short squeeze.
 
For the medium-to-long term, Felix thinks the dollar’s rally has a lot further to go, likening it to the bull markets of the 1980s and 1990s. For the near term, however, the extreme move in the greenback that has grabbed the media’s attention is likely to pause or correct, given the huge long positions that have been amassed by traders.
 
But, he emphasizes, these moves are based on fundamentals. The dollar is strong because growth is flagging in Japan, Europe, and the emerging markets. As for the U.S., he sees growth stuck around 2%, at best, rather than “normalizing” in the 3% to 4% range.
 
“The function of the currency markets is to reallocate growth,” Felix explains. The weak dollar that followed the Fed’s QE boosted U.S. growth, which will be reallocated to other parts of the world. But as the buck rises, the decline in the euro and the yen raises the danger of “real, serious deflation” as the euro-zone nations and Japan use their cheaper currencies to grab a bigger piece of the global trade pie, which is expanding sluggishly.
 
What these monetary machinations point up is the wide divide between the real economies and the financial markets, Felix emphasizes. The central-bank bond purchases haven’t significantly spurred bank lending in the absence of real credit demand. Instead, banks have plowed money back into bonds, driving down yields, spurring further “recycling” of the money by investors into stocks.
 
As a result, he continues, European equities now are priced on the basis of the negative interest rates that prevail on upward of $2 trillion worth of euro-zone government securities (depending on their yields and prices on any particular day). Relative to U.S. equities, European stocks’ valuations are higher than they were in 2007, he adds. That has been a result of the headlong rush into European equities, including by way of U.S.-listed exchange-traded funds.
 
In the U.S., Felix thinks stocks could make “marginal new highs” but are subject to a significant 10% to 15% correction sometime in the late spring or summer, or perhaps into the fall, somewhat later than he previously expected. That is the likely outcome as the two separate worlds of the real economy and the financial markets spin further apart.
 
HOW MUCH ALL OF THIS will matter to the Federal Open Market Committee when it gathers this week is unknown. We’ll have a better idea after the panel’s decision is announced on Wednesday afternoon and Fed Chair Janet Yellen explicates it in her press conference afterward.
 
The focus, nay, the obsession of market watchers is whether a single word, “patient,” will be removed from the policy announcement. According to the way the Fed is supposed to signal its intentions, the excision of that word would open up the possibility of a rate hike at the June 16-17 FOMC confab.
 
Some economists contend that the dollar’s rise should have minimal impact on the Fed’s decision, because the U.S. economy is relatively “closed,” with a smaller proportion of gross domestic product involving trade than in other nations. By that standard, exchange rates don’t matter all that much.
 
For the Standard & Poor’s 500 companies, however, it’s a different story, as some 40% of the earnings of these mostly multinational companies come from abroad. So, once again, this obsession with the dollar could be an example of the divide between the financial markets and the real economy. And by that criterion, the Fed would do well to consider signals from the latter and begin the process of lifting its rate target from near zero.
 
But, given the growing signs of weakness at home and abroad, hiking rates in the near term would make the folks at the Fed a bunch of “blockheads,” contends Jeffrey Gundlach, the head of the DoubleLine asset-management complex. Gundlach’s views became the buzz of the market when they were discussed a few months ago in this space by my learned colleague, Jon Laing. Gundlach’s characterization also likely raised more than a few eyebrows after he let loose in his conference call to investors last week.
 
Other, more circumspect institutional investors invoked precedents of past policy blunders. Most notable was that of 1937, when the Fed tightened monetary policy by effectively draining the excess bank reserves it had created, out of fear that the surfeit of liquidity would create inflation or push up asset prices excessively.
 
So, after a partial recovery from the devastation of the early 1930s, the central bank (with the help of tax increases and spending cuts on the fiscal side) managed to create the second down leg of the Great Depression.
 
History may not repeat, but as Mark Twain famously observed, it does tend to rhyme. One contingent at the Fed contends that the ideal time for the central bank to have hiked rates was last year. The fall in the unemployment rate to 5.5%, they argue, signals that the slack is out of the labor market and that crisis-level zero-interest rates are no longer appropriate.
 
By the same token, the Fed’s other policy measure, inflation, remains far below its 2% target. That’s even after ignoring the 0.5% fall in the producer price index for February, which the lynx-eyed Joshua Shapiro, chief U.S. economist at MFR, pointed out was “massively distorted” by “foolish” seasonal adjustments.
 
In any case, the stock market is acting as if the Fed will follow through and initiate its rate-increase campaign in June. The Dow Jones Industrial Average shed another 146 points on Friday, which was about half of its loss at the session’s low, amid concerns as the dollar spiked to a 12-year high against the euro.
 
Closer to home, and perhaps more relevant to U.S. businesses competing with our closest trading partners, the Canadian dollar fell to a six-year low, while the Mexican peso languishes near a historic nadir. Meanwhile, oil’s bounce appears short-lived, with U.S. benchmark crude ending on Friday at $47.30 a barrel, a six-week low, amid bulging inventories.
 
So, could the Fed signal the possibility of the first rate hike amid the deflationary effects of the rising dollar and falling commodity prices, not to mention tepid wage gains? Do government officials ever commit blunders? The question contains its own answer.