The dollar is the most influential asset in world markets.
The globe’s financial system remains on a dollar standard and the vast majority of debt across the world is dollar denominated.
Much of that debt was taken out at interest rates of sub 1 per cent, as the US Federal Reserve flooded the world with cheap liquidity. The Fed has since abandoned the monthly $85bn of stimulus and the topic of raising interest rates is on the agenda for the first time in many years.
As a result, last summer we began witnessing a significant shift in the pricing of the dollar. There have been moves of 20 per cent-plus in the world’s reserve currency, which is not usually witnessed in a ‘normal’ economic cycle.
The dollar began to rally aggressively as the carry trade embarked on the great unwind, with the dollar index – a measure of the value of the greenback versus a basket of other currencies – moving from 79 to 100.
Many market participants will recall the Fed’s tightening cycle of the 1990s, which played a role in the default of Russia, the Asian financial crisis and the subsequent demise of hedge fund Long-Term Capital Management.
Emerging economies this time may be as vulnerable as they were then.
The capital flows paint a picture of a great wall of money moving into emerging markets over the past 10 years, so a repatriation of assets triggered by a closing out of the carry trade will have significant consequences.
Of that $9trn, circa $6trn is emerging market dollar debt, which is in a currency those countries cannot control, creating a concerning liability mismatch.
Dollar debt of emerging market economies has increased threefold in a decade. During the previous 200 years, very few cross-border lending cycles measure up to the scale of this dollar-denominated debt binge fuelled by quantitative easing and a near-zero interest rate policy.
Slow-growth economies that are associated with commodities, all of which are priced in dollars, are in danger of getting pillaged in broad daylight. Anyone who bears the scars from the Mexican peso or Asian financial crisis will testify that unwinding carry trades can get pretty ugly.
The oil price adjustment in 2014 was the culmination of a number of factors. Of course, it was related to supply-and-demand dynamics, but it was also exaggerated by dollar strength. This was not coincidental, and it would be incredibly optimistic to assume this unwinding process is over.