The US is finally back, while the rest of the world seems stuck in the doldrums.
In principle, this divergent dynamic shouldn’t concern investors. But in practice, the consequences of global de-synchronisation can be painful. The problem is the price of the dollar, because it is the currency not just of America, but of the world.
An increasingly healthy American economy implies that the era of cheap US currency is over. And while increasingly expensive money might be just right for an accelerating US, it may be the last thing that the rest of the world needs.
History teaches us that a reinvigorated US dollar exposes those whose balance sheets were built on the belief that cheap money would last forever. It acts like a depth charge, exploding deep below the surface of the ocean. First, the minnows float to the surface, then the bigger fish, and finally one or two real whales.
The minnows have popped up already. Emerging market equities, bonds and currencies were quick to crack when the Fed first broached tightening back in mid-2013. The adjustment has been brutal and perhaps a bit too indiscriminate.
The bigger fish will be closer to the core of the US economy. High-yield corporate bonds represent the part of the corporate sector most dependent on cheap debt. Now credit spreads are paper-thin, covenant quality is deteriorating and liquidity is frighteningly low.
What about the whales? They are the most difficult to spot, but to my mind three candidates stand out.
The first is the Asian dollar bloc. If the dollar continues to strengthen – and the Japanese yen, a major competitor, continues to weaken – the rationale for competitive devaluations may become irresistible. The most important member of this group is China – and the consequences of a policy-driven devaluation by the world’s second-largest economy would be profound.
A second potential whale is sterling. At nearly 6 per cent of GDP, the UK’s current account deficit has grown to alarming proportions. For now, this gigantic imbalance in our external payments is easily financed. But if the world’s reserve currency gets more expensive, that may change – and quickly. If history is any guide, a steep depreciation of sterling to reflect the new reality is likely to be the result.
That brings us to the biggest whale of all. Everything above is predicated on the assumption that America’s current economic buoyancy will translate into higher interest rates and a stronger dollar. There is another possibility: the US itself is not ready for more expensive money.
The recent strengthening of the US dollar and sharpening of the Fed’s hawkishness has been met by a sustained rally in long-dated US Treasuries. The resulting flattening of the yield curve has historically been one of the more reliable indicators of coming economic weakness. An obvious interpretation of this dissonant market action is that we may not be in a two-speed world after all – or not for much longer.