STRONG DOLLAR = INTERNATIONAL CARNAGE / MACLEOD FINANCE

Strong dollar = International carnage

President Trump’s proposed policies will raise bond yields, lead to a strong dollar against other currencies, and by popping the credit bubble drive the world into an economic slump.

ALASDAIR MACLEOD

Introduction

In earlier articles and interviews I have drawn attention to the accumulation of credit bubbles which have never been allowed to wash out malinvestments and eliminate debt zombies. 

Consequently, previous bubbles have been rolled up into the largest dollar-based debt bubble in history, extending risk into other major currencies as well.

So far, US interest rates and bond yields have risen from the zero bound to the five per cent level, which have so far been insufficient to pop the credit bubble. 

Instead, equity markets have continued rising. 

But all credit markets have become inherently unstable.

Will a new and unexpected increase in interest rates and/or bond yields pop the bubble? 

And what will be the consequences for the other major currencies? 

These are the questions I attempt to answer in this article.

Interest rate expectations are mistaken

Financial gossip today is of how strong the US economy is going to be under President Trump. 

And a strong economy means a strong dollar relative to other currencies due to the implications for interest rates. 

They are already beginning to be discounted in currency markets, which changed the dollar’s direction the moment Trump won his election. 

This is reflected in the performance of the dollar’s trade weighted index, illustrated in the chart below:

Not only has the TWI completed a basing pattern by breaking above the pecked line, but it has done so forming a bullish golden cross underneath the rising price. 

It tells us that the TWI is indisputably in a bull market, a challenge of the September 2022 high of 113.30 is on the cards, and that it has the potential to go far higher. 

It is confirmation that the spread between dollar interest rates and those of the other major currencies will increase.

This is demolishing the euro, yen and pound. 

Charts of the euro/dollar and yen/dollar (inverted) illustrates how much ground they have lost to the dollar already. 

The strong dollar is likely to drive the euro below parity, and the yen will sink towards 200.

But there are still hopes that interest rates will not rise. 

This is a current quote from a market reporting website: “Markets favour the outlook that the Fed will deliver one sole rate cut this year, currently priced for the third quarter.” 

That is unlikely to happen, and dollar interest rates are set to go higher, not modestly lower. 

The reason is that the dollar is losing purchasing power at a faster rate than the heavily doctored CPI indicates, which is reflected in its price relationship with real legal money, which is gold. 

It requires higher rates to be stabilised, not lower. 

This is in the next logarithmic chart:

 Against gold, the decline in the dollar’s purchasing power since 2016 averages a compound rate of just under 9%, closer to independent estimates by Shadowstats.com than official CPI estimates. 

Furthermore, the rate of decline appears to be accelerating.

Despite lower reported inflation rates in Japan and the Eurozone, their currencies have lost more purchasing power than the dollar. 

This reflects currency weakness rather than a statement of true inflation and is due to their lower interest rates. 

However, all four currencies appear to be losing purchasing power at an accelerating rate.

Why Trump will burst the credit bubble

There is no doubt that the world is in an enormous dollar-based credit bubble, being a rolled up accumulation of tin-cans being continually kicked down the road since the mid-eighties. 

Every credit cycle ends with higher interest rates and bond yields, and this one is doing just that. 

Consequently, it is collapsing almost all fiat currencies relative to the dollar, hitting emerging nations with dollar debt particularly hard.

Trump’s economic policies can be expected to deliver two material influences on this outlook. 

First, he has promised to use trade tariffs to supplement government revenue and as a replacement for direct taxes on individuals and corporations. 

Trade tariffs are expected to disadvantage the EU and possibly Japan. 

Under its heavily socialist government, Britain’s position with respect to US tariffs is currently uncertain.

Europe particularly is likely to respond with higher tariffs and trade restrictions against American goods, as is China. 

China is not the focus of this article, other than to point out that if China responds with tit-for-tat trade tariffs, we could have a modern doppelganger for the Smoot-Hawley Tariff Act which drove both the US and the rest of the world into the 1930s depression. 

Furthermore, tariffs are paid for by consumers, so the consequences for US consumer price inflation will make it impossible for the Fed to reduce rates and force it into raising them instead. 

That is so long as the Fed respects its inflation mandate, which for now we must assume will be the case.

Secondly, the much-vaunted growth in the US economy is in fact the product of a budget deficit which will likely increase in the short-term. 

Budget deficits are horribly inflationary because they represent an unproductive increase in credit circulating in the economy. 

Adjusting growth expectations for this fact, we note that a fiscal-2025 budget deficit is likely to be about 8% of GDP, almost all of which is spent in the domestic economy. 

Therefore, it overstates GDP growth accordingly and compares with the Congressional Budget Office’s current forecast of 4.5% GDP growth (estimate released on January 7th). 

In other words, the excess issue of credit conceals a contracting private sector measured by its share of nominal GDP.

This is not the story macroeconomists are telling us. 

Instead, they have the US economy growing at the fastest pace of all the majors. 

But adjusted for government-induced credit inflation it is already in recession.

So much for statistical analysis and its relationship with the truth!

International capital, which determines the marginal pricing of US Government debt is partly reliant on the expansion of bank credit to fund government budget deficits. 

But banks everywhere are overleveraged relative to their equity bases and are reluctant to expand their lending further. 

This means that lending to the government results in credit being withdrawn from the private sector, undermining private sector GDP and pushing it into recession. 

This is further confirmation that the US economy is in recession, except, that is, for the Federal Government which continues to expand.

So far, the US Treasury has benefited from bank credit migrating from the private sector to the relative safety of treasury bills and short-dated bonds. 

Consequently, bank credit committees will be pointing out to their directors that they are already very overweight in government paper, which might be a matter of concern.

This is why it requires higher, not lower interest rates and bond yields to fund a $2+ trillion budget deficit when the US Government’s debt to GDP is already about 125% or more — much of it short term. 

And to understand the prospective course of dollar rates and their consequences for Europe, Japan, and also Britain we must start with the prospects for the dollar’s exchange rate with them.

The simple answer is interest rate differentials. 

The ECB’s overnight rate is currently 3.15% and the Bank of Japan’s is 0.12%. 

Both currency areas have been caught flat-footed by rising US interest rates and bond yields, and the likely direction of dollar interest rates in the years ahead will have a profound impact.

In setting interest rates, the Fed will be primarily concerned about the inflation outlook. 

The combination of a widening budget deficit and increasing import tariffs will lead to higher, not lower dollar interest rates. 

We can dismiss the employment mandate because the estimates are managed with a view to painting a good picture, management which is likely to continue to make them meaningless.

Markets are waking up to the consequences of Trumpian policies and have already been selling euros and yen, as the second chart above in this article demonstrates. 

But with markets still discounting one further rate cut from the Fed, the factors driving rates and bond yields higher are yet to be priced in market valuations.

Higher interest rates always occur at the end of a credit bubble, and it is this which pops it. 

The next chart of the Fed Funds rate and the official recession bars which follow demonstrates this nicely:

Recessions follow every rate peak, with the sole possible exception of the mid-eighties. 

The only other thing missing is the recession bar for 2025—?.

With interest rates having further to rise, a deep recession is pretty much guaranteed. 

Equity and crypto bubbles will be the first to deflate, followed by multiple bankruptcies in the private sector, threatening banks’ survival particularly in Japan and Europe where balance sheet leverage is greatest. 

Owning any form of credit, including currencies will become extremely risky.

Meanwhile, we can expect the more prescient members of the global financial community to increasingly dump collapsing credit for gold, which is real legal money without counterparty risk. 

And an examination of the third chart above of major currencies priced in gold shows that the rate at which the dollar and other major currencies are losing purchasing power already appears to be accelerating.