The reality is that we're
one panic away from foreign-exchange markets ripping free of central bank
manipulation.
While all eyes on fixated on global stock markets as the measure
of "prosperity" and "growth" (or is it hubris?), the
larger force at work beneath the dovish cooing of central bankers is foreign
exchange: the relative value of nations' currencies, which are influenced (like
everything else) by supply and demand, which is in turn influenced by interest
rates, perceived risk, asset purchases and sales by central banks and capital
flows seeking the lowest possible risk and the highest possible return.
Which brings us to Triffin's Paradox, a
topic I've covered for many years:
Understanding the "Exorbitant
Privilege" of the U.S. Dollar (November 19, 2012)
The Federal Reserve, Interest
Rates and Triffin's Paradox (November 19, 2015)
The core of Triffin's Paradox
is that the issuer of a reserve currency must serve two entirely different sets
of users: the domestic economy, and the
international economy.
The U.S. dollar (USD) is the global economy's primary reserve
currency. When the Federal Reserve lowered interest rates to zero (Zero
Interest Rate Policy, ZIRP), it weakened the dollar relative to other
currencies. In this ZIRP environment, it made sense to borrow dollars for next
to nothing and use this free money to buy bonds and other assets in other
currencies that paid higher yields. Many of these assets were in emerging
market economies such as Brazil.
As a result of this enormous carry
trade, an estimated $7 trillion was borrowed in USD and invested in other
currencies/nations.
Once the Fed started making noises about
"normalizing"/raising interest rates in the U.S. (i.e. signaling the
markets that a trend change was at hand), the dollar strengthened and the carry
trade started reversing: those who had bought assets in other currencies
with borrowed USD started selling those assets, which pushed emerging
market currencies and markets off a cliff.
Meanwhile, since China pegs its currency the yuan/RMB to the USD,
the rising dollar dragged the yuan higher thanks to the peg. A
strengthening yuan made China's exports more expensive and less competitive,
the last thing China needed as its domestic credit bubble ran out of steam.
So while the Fed needed to "normalize" rates in the U.S.
before the next recession required more Fed stimulus, it also needed to weaken
the USD to protect China from a destabilizing currency devaluation.
Those holding millions of soon-to-be-devalued yuan in China were
naturally anxious to convert their yuan into USD before the devaluation robbed
them of 25% of the purchasing power of their money, and this has created an
unprecedented capital flow of cash out of China and into USD and other Western
assets, such as chateaux in France, homes in Vancouver B.C., etc.
This mad rush of capital out of China is adding another
destabilizing factor to China's already wobbly debt bubble economy, and China's
weakness has weakened an already wobbly global economy crippled by stagnation
and the decline of emerging markets and commodities--two consequences of the
rising USD.
This has created a no-win conundrum for the Fed: if it
normalizes rates (as it should, after seven years of ZIRP and stimulus) in the
domestic U.S. economy, that will strengthen the USD, further pressuring China's
yuan and emerging markets, which in turn will further pressure an
already-tottering global economy.
There are no winners, regardless of what policy the Fed chooses to
pursue. This is why we see such absurd waffling in the Fed: one statement
suggests interest rates hikes are on the way, and the next dovish cooing
suggests rate hikes are so far away that global markets can safely ignore the
possibility.
This push-pull is reflected in the chart of the USD:
As the Fed waffles in response
to global markets, the USD has swung up and down in a trading range.
Sorry, Fed: you can't have it
both ways. Eventually, the domestic
economy will pay the price of essentially zero interest rates, or China and the
global economy will pay the price of a strengthening USD.
No nation ever achieved global hegemony by devaluing its currency.
Hegemony requires a strong currency, for the ultimate arbitrage is trading fiat
currency that has been created out of thin air for real commodities and goods.
Generating currency out of thin
air and trading it for tangible goods is the definition of hegemony. Is there
is any greater magic power than that?
In essence, the Fed must raise rates to strengthen the U.S. dollar
(USD) to keep commodities such as oil cheap for American consumers. The
most direct way to keep commodities cheap is to strengthen one's currency,
which makes commodities extracted in other nations cheaper by raising the
purchasing power of the domestic economy on the global stage.
Another critical element of U.S. hegemony is to be the dumping
ground for the exports of our trading partners. By strengthening the dollar,
the Fed increases the purchasing power of everyone who holds USD. This lowers
the cost of goods imported from nations with weakening currencies, who are more
than willing to trade their commodities and goods for USD.
What better way to keep bond yields low and stock valuations high
than insuring a flow of capital into U.S.-denominated assets?
There is one more destabilizing possibility: the markets may push
the USD higher, regardless of what the Fed says or does. The
currency markets trade $5 trillion a day--more than the Fed's entire $4
trillion balance sheet.
Once traders realize China will have to devalue the yuan by a lot
more than a few baby-step devaluations, the stampede into USD could overwhelm
even coordinated interventions by central bankers.
Of course no central banker will ever admit that markets could wrest
free of central bank control, but the reality is that we're one panic away from
foreign-exchange markets ripping free of central bank manipulation.
