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How the Greenback could affect the global economy

How the Greenback could affect the global economy

It’s that time of year.

The editorials start appearing, summing up the performance of stocks, commodities or gold.

As an Australian reader, it will come as no surprise to discover the big four banks are down an average of 12% since the start of the year.

To date, Rio Tinto is a couple of bucks down and the other mining giant, BHP, is a couple of bucks up.

All up, the S&P/ASX 200 is down around 7% for the year to date.

Give it a week or two, and then the 2019 forecasts will start to roll in. What will be the ‘hot stock’ next year? Which sector is set to soar?

I could go on. But I won’t. You go head to any of the mainstream rags for that.

I want to talk about something completely different.

A different kind of forecast for 2019.

I mentioned it in yesterday’s Daily Reckoning Australia.

The biggest threat to your wealth is unravelling right now.

And almost no one is talking about it.

US$11 trillion worth of reasons to worry

The mighty US dollar.

It’s the epicentre of the global financial system.

The safe-haven asset for global markets and investors.

And yet the greenback — the very currency that underpins the entire global market — could actually trigger the next financial crisis.

That’s a bit dark, isn’t it?

‘Wait,’ I hear you say, ‘There’s no way US policymakers would let that happen. They bailed out Wall Street in 1997 and the financial market in 2008. Won’t they just do it again?’

Not this time.

They can’t.

The value of US dollar debt outside of the US hit US$11 trillion this year.

That’s a 5.2% increase on the year before. And the vast majority of this debt is sitting in emerging markets.

The strong US dollar is its own enemy

There has been persistent strength in the US dollar this year.

And for once, it’s not a good thing.

For starters, the more the US dollar is worth, the more of a local currency is required to pay back the US dollar loans.

So suddenly those emerging market loans become increasingly difficult to pay back. Meaning that the default risk jumps.

As more investors rush out of emerging market currencies — like the Chinese renminbi, Brazilian real and Russian ruble — it weakens the local currencies.

When a currency weakens, more of it is needed to pay off US dollar-denominated debt.

As you know, investor capital flows to markets where it can see higher returns with limited risk.

Already we’ve seen three rate hikes from the Federal Reserve this year. The higher rates in the US are bringing more capital into the country, for two reasons.

Firstly, money flows to where it will make more money. Secondly, there is the perceived safety of the US dollar and the US economy.

Take India, for example. India’s cash rate is 6.5%, yet foreign investors don’t consider funds stored in India as safe as those stored in the US.

Even though the Fed funds rate is 2.25% today, investors trade in the higher return for the assurance that their money is safe.

So, this means there’s a bunch of US dollar-denominated loans in emerging markets that are getting harder and harder to pay back.

That alone is a debacle waiting to happen.

To compound the problem, we have the Federal Reserve Bank raising rates.

Every interest rate hike effectively shrinks the US money supply.

In other words, there’s less US dollars in the financial system.

On the surface, that sounds like a good idea though, doesn’t it?

Many people are frustrated with the dominance of the greenback. A few less floating around the world sounds like a plan.

Except, that’s not the case.

No greenbacks, big problems

As I said before, the US dollar is the linchpin of this fiat money system we operate in.

All commodities express their value in US dollars. Most major currencies have their ‘strength’ compared to the US dollar.

But here’s the thing.

Because the US dollar is the epicentre of the financial world, America can run up enormous deficits because it knows there is still a demand for US dollars.

Central banks and governments around the world buy US Treasury bonds, as part of their foreign reserves, to protect themselves in a crisis.

And the more US bonds they buy, the more ‘money’ the Federal Reserve can print.

In essence, this supports the value of the US dollar.

In turn, the US government can keep running up its trillions of dollars in government debt, believing that everyone will always want US dollars.

It’s been this way for almost 40 years.

But there is a very real chance that this cycle is about to come to an abrupt halt.

That there will be less demand for US dollars.

Russia has completely dumped its US Treasury holdings this year. Both China and Japan have reduced how many US bonds they bought this year.

In fact, this year saw the ‘weakest foreigner participation’ in US bond auctions in a decade, according to Reuters.

If this continues, that will shrink the supply of greenbacks. Or, as Jim Rickards calls it, there’ll be a ‘shortage’ of US dollars.

Given that there is no other dominant currency to replace the US dollar, a drop in greenbacks is an enormous problem.

And this is nowhere in the news today. No one is talking about what happens if the rug is whipped out from under the financial system.

Except us.

Back in May, Jim Rickards and I collaborated on a report explaining this very problem.

So, while you’ve spent the morning running form headline to headline, there’s a much bigger story brewing behind the scenes.

The reason why you heard it here first? No one else was looking.

Remember this as the market forecasts for 2019 start to roll out over the next month.

Because if we’re right, the ‘shortage’ of US dollars could turn the monetary system on its head, and crash stock markets around the world.

Until next time,

Shae Russell Signature

Shae Russell,
Editor, The Daily Reckoning Australia