How the almighty dollar reigns supreme

How the almighty dollar reigns supreme

This originally appeared in Rutgers Business Insights on Fri, September 23, 2022


 
Finance and economics professor Farrokh Langdana provides five reasons why the U.S. dollar is strengthening. He also demystifies carry trades, taper tantrums and shorting.
 

This blog was inspired by responding to questions from students and alumni in the Rutgers Executive MBA program about the current economic climate. Rutgers EMBA program has been repeatedly ranked in the Top 3 in Economics worldwide by Financial Times (2018, 2019, 2020, 2021).

Professor Langdana, what makes the U.S. dollar so “almighty?” And for how long?

First, “Welcome to the Powerhouse”, the sobriquet of the Rutgers Executive MBA Program.

Regarding the question, what we have now is a “perfect storm” for dollar appreciation or “dollar strengthening.” This dollar’s strength is driven by five factors.

#1 Interest rates are going up.

The Fed is pushing interest rates up to slow down inflation to try and “engineer a soft landing[see video].” This makes our higher interest rates now more attractive to foreign investors. So, they convert their currencies to US$ to take advantage of our high-interest-paying investments (Treasury bills, bonds, and CDs, for example). The demand for US$ increases, and consequently, so does its price—which is exactly what “dollar strengthening” means.  The U.S. dollar now simply costs more in terms of foreign currencies.  

#2 The U.S. is the world’s “flight to safety” destination. 

In our language, the U.S. is still “the safest cave.” Irrespective of interest rates, if things globally are dicey and shaky, investors will rush their capital here to shelter from the storm.  If most of world’s countries are huddling in their own “caves” to shelter from whatever macro/political/exogenous crises, we, in the U.S. have the “best” and “safest” cave.  After all, everything is relative. 

The U.S. is the #1 “flight to safety” destination for global capital exodus from adverse shocks such as China-Hong Kong, Russia-Ukraine, Brexit, Eurozone blues, Sri Lanka meltdown, various ongoing hyperinflations, weather shocks, etc.  This has been discussed in my other blogs [see page].

At this moment, the rest of the world still seems to be attempting to recover from the Covid-Ukraine era. As a result, the U.S. is experiencing a massive hot capital inflow into its “safest cave” from China, Hong Kong, Russia, Europe, and even India, among others.  Much of this capital inflow eventually finds its way into the stock markets or into real estate—especially high-end real estate, thus making it more expensive for the rest of us and further inflating our bubbles in real estate and equities.

The U.S. isn’t the only “flight to safety” destination. Singapore is one and is the beneficiary of huge capital inflows from China and Hong Kong at the moment, and of course, from Russia. Canada and Switzerland could also be considered safe havens too, but the list, sadly, is not long.

#3 Growing economy in the U.S.

Global capital is also attracted to economies that are growing now and expected to continue to do so in the near future. We are plodding along at 1.7% growth and our deficit/GDP ratio at 3.9% has mercifully fallen back to the “sustainable” rate…we are not looking stellar, but we are good. 

#4 “Shorting.” 

“Shorting” is when investors expect the value of an asset to fall in the near future and hence, they indulge in arbitrage to ensure a sure profit. “Arbitrage” is the purchase and sale of the same asset at different points in time (see example below) to ensure a sure profit.

Let me explain.  If some foreign currency FX is now trading at 1 of FX =10 US$. And if the US$ is expected to get stronger in the near future (say, on Day 30) to 1 of FX=just 6 US$ on Day 30, then investors can “short” the FX today. In other words, they will take 1 of FX and buy 10 US$ today, and then on Day 30, after the dollar has become even stronger, as expected, they can then take their 10 US$ and “come back home” to FX at a much better rate!  In this highly simplified example, they can now “come home” to more FX and make a 67% profit. 

But when thousands of investors play this game today, at 1 of FX = 10 US $, they further weaken their FX and further strengthen the US$. Hence, this process of “shorting” FX today, may result in the dollar now further strengthening to 1 of FX = just 5 of US$ on Day 30!  The shorting today may actually serve to exacerbate the plunge in currencies around the world and the surge in the US$!

It is no wonder that the dollar is living up to its “almighty dollar” heritage and we aren’t even on the fifth reason yet!

#5 Supply chain issues.

The fifth reason is that while reasons 1-4 are all driving the dollar up, the rest of the post-Covid world is still reeling from its supply chain issues exacerbated even more by the China lockdowns and the Russian invasion. Oil prices, weather shocks, food shocks, war, Covid-devastation…problems abound. These are all reasons enough for investors from the recession-prone economies to short their own currencies today and “park” their savings in a safe haven such as the U.S. or in Singapore.

And finally, professor, what are “carry trades” and “taper tantrums”?

When investors borrow from a home country where interest rates are close to zero percent at home—as in the US, Japan, and the Eurozone during Covid–and then park their funds abroad in economies that may be growing better or offering higher rates on their savings, they are “carrying” their funds from the home (country A) to some higher-interest-rate country B.  Hence, “carry trades”.  But keep in mind that whenever capital leaves the home country (A)—it MUST come back home eventually; otherwise, what is the point?

When A starts to drive up its interest rates to cool down its economy and to bring its inflation down, the “carry trades” now rush back home to A. Country A has just “tapered” its monetary growth to push up its interest rates to try and soft-land its economy. If country A does this with little or no warning, then A just threw a “taper tantrum.” 

Presumably A is also a safe haven economy.  So, when this happens, B, unfortunately, experiences a hot capital outflow. This is devastatingly painful for B.  Its currency plunges as investors convert back to A’s currency as they rush back home to A; B’s interest rates spike as capital rushes out, and loans made by B in A’s currency are now very hard to service. 

Bankruptcies and defaults plunge B into macroeconomic doom. If B is importing oil, pharmaceuticals, medical supplies, etc., B finds them now impossible to afford with its collapsed currency. Imports become exorbitantly expensive for B.  No.  This is not good. Riots in the streets. Smoke on the water. Fire in the sky.

Wow. So then, the moral of the story?

The US$ is strong now and poised to remain so for the foreseeable future.  Message to Putin and his fellow dictators: I recommend not shorting the United States or its currency. Just mindlessly crowing about one’s currency does not make it strong. A currency’s strength is endogenous—it is market driven, organic.  It is, mercifully, not a propaganda event or a social media goal. “Go long” on the U.S. dollar. Always.

The comments here are solely those of Prof. Langdana and should not be attributed to Rutgers University.

For more of Prof. Langdana’s blogs please visit his Faculty Blog: business.rutgers.edu/Langdanamacro.

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