Attention has rightly been focused on the collapse of oil prices over the past 6 months. These have further to fall, but the major part of the move must now be behind us. After all, Brent was at $104/bbl when I first forecast the move in mid-August, and closed at $56/bbl last night, so probably “only” has $20/bbl-$30/bbl further downside.
But there are 2 elements to this Great Unwinding. The other is the surge in the value of the US$. The US$ Index (versus the world’s other major currencies) has already broken out of its 30-year downtrend since my August forecast.
I suspect the US$’s resurgence will now assume much greater importance as its impact becomes more widely recognised.. As I noted back in September:
- “The US$ Index has fluctuated 25% on several occasions between 72 and 90 since the middle of 2008
- First there was a ‘flight to safety’ in H2 2008, as the Financial Crisis took place
- Then the US Fed pushed the value down again with its first Quantitative Easing (QE)
- When traders tried to buy the US$ again in 2010, new QE programmes kept the $ weak..
“If we assume for a moment that the US$ continues to rise, then the recent flows of money into high-risk assets will quickly reverse. These have been largely created by the Fed’s decision to supply unlimited amounts of low-cost money:
- Pension funds and hedge funds have simply bought anything that offered a high yield, in a desperate effort to maintain their returns for investors and pensioners
- They have only thought about the need to focus on ‘reward’, and have ignored the fact that high reward usually also means ‘high risk’
“But if money flows back into the US$, then ‘risk’ will return with a bang. Who will buy all the assets that are being sold?”
Today, this is no longer a theoretical question, as the chart above shows. In the 6 months since I forecast the move, the Index has now reached the 100 level, last seen 12 years ago in Q1 2003. That is a massive move in such a short time. And as the New York Times notes:
“The soaring value of the American dollar is rippling across the globe. As it rises, it is threatening emerging economies where companies have taken on trillions’ worth of dollar-based debt in recent years.”
The scale of this risk is not at all well understood. And yet, as I noted last week, US$ debt in the Emerging Markets has grown 20-fold from $0.1tn to $2tn over the past decade. It is larger than the US high-yield corporate bond market, and 4x the size of Europe’s high-yield bond markets.
High yield always means high risk. But at least some investors have a good understanding of the risk in US and European bond markets. Very few have the same understanding of the Emerging Markets. Most investors have simply bought their bonds from a prospectus: they were desperate to gain a better yield than available in the West.
Now they will find out the hard way that that many of the companies in which they have invested cannot afford to repay the loan, due to the loan’s value having just increased dramatically due to the rise in the US$. The sorrowful sequence is as follows:
- Companies in Emerging Markets decided to borrow more cheaply by borrowing in US$
- Their aim was to take advantage of the US Federal Reserve’s zero interest rate policy
- But today they are finding out the real cost of the loan, as the capital value has risen by up to 50% in some cases, such as Russia
- So, of course, they are most unlikely to be able to repay the loan, especially as their profits are also under pressure from the slowdown in China and other Emerging Markets
The US$ has been in a downtrend for 30 years, since the Plaza Accord in 1985. Now, as often happens, the recovery is happening very fast indeed. It will be a very bumpy ride ahead.