It is no secret that the US economy exerts a significant influence on other economies around the globe. The release of key economic statistics in the US are cast out very quickly to reach other stock, bond, and most importantly, foreign exchange markets. This occurs in both the developing and developed world, but, arguably, more so for the former given their high dependency on global trade flows.
Last week strong retail sales data in the US pushed the dollar to a 16-month high against a basket of currencies.
Chart 1: DXY Currency Index Jan 2020 – Date
Source: Bloomberg, 2021
Retail sales were 1.7% higher in October than the previous month. Healthy yes, but not remarkable. Other factors behind this number proved more influential. With inflation on the rise, concerns that shoppers, deterred by inflated prices, would scale back on purchases. However, this turned out to be a wrong assumption. Even taking account of the fact that higher prices are embedded in the sales numbers by value, there are few signs of waning demand. As mentioned in previous articles the savings rate in the US and here in the UK is elevated giving a lot of spending power.
Chart 2: US Retail Sales – MoM (%)
Source: Bloomberg, 2021
Meanwhile, expectations remain that the Federal Reserve will implement interest rates to rise gently, but faster, if necessary, to slow consumer demand and combat any threat that higher inflation will not prove transitory. The upshot of this for foreign exchange markets is dollar bulls are in the ascendency. They are comforted by the fact that even if inflation doesn’t start to recede next year, as shortages ease, the Fed will act decisively. Moreover, they seem convinced that demand for manufactured goods and services (particularly the latter) will remain healthy even as interest rates go up.
A technical and important point to make here is that if nominal Gross Domestic Product (the value of goods and services) stays healthy and inflation falls as predicted, real GDP will rise. This notion of rising real GDP is giving support to the dollar. Moreover, added impetus for the dollar will follow if interest rates start to rise moderately without destabilising growth. The so-called path of policy normalisation.
There are of course always competing views around any currency. Dollar bears point to the large US trade deficit and that all things being equal the deficit needs a weaker dollar in order to restore some degree of balance in the US’ terms of trade i.e. a weaker dollar cheapens US exports and makes imports into the US more expensive.
What then if the bulls are correct and the strong US dollar view prevails? There are several implications. One of the more noteworthy ones is how this impacts emerging economies (EM). In general, local EM currencies tend to weaken on dollar strength.
We already have some evidence of weakness taking place in response to the retail sale data release. On the day the MSCI Emerging Markets Currency Index fell 0.29%. Not massive, admittedly, but within the constituents there were some big individual country adjustments. For example, the Turkish Lira falling almost 3%, while South Africa’s rand, Mexico’s peso and Russia’s rouble all suffering heavy 1 to 2% one day falls.
In some respects cheaper EM currencies have positive effects. They lower exporting costs which is particularly beneficial for commodity exporters and economies where manufactured goods are the main export. On the downside many EM economies have sizeable dollar debts financed out of revenues in their own currency, and of course a weaker currency can propel inflation higher too by importing price inflation.
Ulrich Leuchtmann, an analyst at Commerzbank wrote about this aspect last week when referencing developments in Turkey’s currency market,” the lira was suffering from its own momentum, with a “vicious circle” driven by higher inflation causing the lira to weaken and a weaker currency sending inflation higher”.
To put this into in perspective, Turkey’s latest annualised inflation rate is 19.9%, nearly 4 times that of the US.
Spending data show US consumers able and willing to absorb inflating goods prices. Consequently, the US dollar has strengthened based on expectations that price inflation will fall back next year and growth will remain robust.
Moderate interest rate rises may be required in 2022, and beyond, as inflation settles slightly above the average inflation rate exhibited over the course of the last cycle (approx. 2%). This is comfortable for most investors.
On the flip side, if the dollar continues to attract more support many emerging market economies, notably Turkey, will see their currency weaken. A strong US dollar has implications for future inflation expectations in EM economies bringing with it a need for high interest rates – ‘a vicious circle’.
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