A few weeks ago, we heard HSBC chief economist Stephen King announce projections for the global economy over the next decade. Many reading this will already be familiar with his conclusions, but as a quick outline, he suggested that six years into a recovery, we’re likely closer to the next recession than we are from the last. He outlined a number of reasons why this recession could be much worse than the others, primarily focusing on the fact that unlike previous downturn we don’t have any real tools at our disposal with which we can fend off any economic weakness.
King pointed out that, normally, developed economy interest rates will fall by five percentage points in recessionary times, but of course with interest rates at zero already (or less in Europe) this is not a possibility. Further, he pointed out that with current debt levels unsustainable as they are, an extension of any quantitative easing policy would be merely a temporary solution, and one that would likely lead to far worse trouble in the short to medium term. News media picked up on the story and King’s likening of the global economy to the ill-fated Titanic, and our lack of policy tools with which to deal with a recession to the Titanic’s lack of lifeboats. He did, however, make one point that, as currency traders, we may be able to take advantage of.
He gave four potential reasons why the global economy might collapse – four potential icebergs, to stick with the analogy. These included the Fed raising interest rates too quickly and plunging us back into recession; non-banking financial services failing to meet future obligations such as pension funds and an ensuing run towards liquid assets that could lead to panic selling; high US wages with a non-concurrent expansion in output leading to a decline in company profits and, in turn, market capitalization; and finally – the one that we’re interested in – a weakening economy in China.
Why is it interesting to us? Well, it could present us with a long-term bias in the US dollar. For a long time, Beijing has reportedly maintained a certain level of control over the value of its currency, the renminbi. In 2005, China scrapped its policy of pegging the currency to the US dollar, and now, every business day, government workers in the country publish the value of the renminbi versus the US dollar. This value tends to increase steadily every day, and as a result today’s renminbi is worth about 25% more versus the US dollar than it was 10 years ago. However, this sort of appreciation is only sustainable as long as the Chinese economy maintains a particular level of expansion. If expansion wanes, China may be forced to let the renminbi decline in value versus the US dollar.
What does this mean? Well, first off, it will translate to short-term dollar buying, and the associated strength this brings. Further, however, Chinese demand for commodities such as oil, agriculture, mining (especially from Australia) and foodstuff from places like New Zealand, strengthens prices for all these commodities considerably. Once the Chinese economy starts to slide, and it weakens its currency, its demand for these commodities will decrease and their prices will follow.
The vast majority of global commodities trading is done using the US dollar as a means of exchange. So, as commodity prices decline, demand for the dollar will increase. This increase in demand will boost the US dollar medium term – and therein lies our bias. We can also pretty firmly say that in the event of a Chinese slowdown the value of the Australian dollar will also suffer, and present us with a bearish bias in the Aussie. This, however, is only the start. As mentioned earlier, normally we would see the Fed raise interest rates in order to counter a strong US dollar (and the inflation this engenders). However, with such a weak recovery, raising interest rates could be extremely dangerous, and again, as mentioned, could simply plunge the US into further recession. For this reason, the Fed may only be able to raise its interest rates very slowly, through gradual increment. This, therefore, could very easily extend our bullish bias from a medium-term to a long-term one. Further, if we get any potential sell-off in the equities markets as Stephen King also predicts, this could add fuel to the fire as far as a strong dollar is concerned.
So, there we have it. In the long term at least, it looks as though the US dollar is set to strengthen considerably versus its major counterparts.