Looking for an explanation for the rout in emerging market stocks and commodities?
Blame it on the U.S. dollar.
Oh, the original decline in the prices of those assets started in a different quarter with worries that government moves to cut bank lending and to tighten the money supply in China would slow economic growth there—and damp demand for the commodities that China’s economy imports to feed that growth.
But the decline in emerging market stocks and commodities has entered a new stage where the continued strength of the U.S. dollar is a major force pushing the price of emerging market assets (outside of China, which has pegged its currency to the U.S. dollar) and commodities lower.
It works like this.
Many global commodities, such as oil, are priced in dollars. When the dollar rises in value, it takes fewer of them to buy a barrel of oil so the price of oil might fall, say, from $76 a barrel to $74.
That’s important for commodities such as oil. But it’s a relatively small part of the effect of a rising dollar on global asset and commodity prices.
The much more important effect is to cause a massive unwinding of the dollar carry trade.
With the Federal Reserve keeping its benchmark interest rate at 0% to 0.25%, borrowing dollars is cheap. So cheap that it pays to borrow dollars and invest them in commodities, commodity stocks, emerging market stocks and bonds—any asset that looks like to outperform U.S. dollar-denominated assets.
At least it pays as long as the U.S. dollar is either stable or better yet falling in price. If the dollar is falling in value, it means a borrower will be able to repay that dollar-denominated loan in the future with dollars that are worth fewer Euros, or Canadian loonies, or Brazilian reals.
If the dollar starts to climb in price, however, borrowers face a tough decision.
If the decline looks likely to be only temporary, then hanging on to current positions makes sense. No need to sell Australian bonds or Brazilian stocks now, if the dollar is about to go back into retreat soon.
But if the dollar’s advance looks like it’s going to last for a while and produce a sizeable gain in the price of the dollar, then it’s smart for borrowers to sell their commodity positions, their Indian stocks, their Turkish bonds so they can repay their loans with dollars that are only modestly more expensive than they were a week or two before.
Last thing anyone wants to do is get caught short U.S. dollars when the dollar is staging a big rally.
Well, much to the surprise of many traders short the U.S. dollar, the dollar has staged a big rally. On Friday, January 29, the U.S. Dollar Index hit a five-month high.
And it looks probable that the dollar rally is going to continue for a while.
That’s because the drivers of this rally—the weakness of the euro and signs that the U.S. economy will grow faster than that of the rest of the developed world—aren’t done.
The euro currency crisis set off by a larger than expected—a much larger than expected—budget deficit in Greece threatens to spread from Greece to Spain, Portugal, Ireland, and Italy.
Surprisingly robust fourth quarter GDP growth in the United States of 5.7% out distanced any growth in any European economy in the quarter. And while the absolute rate of growth in the U.S. is expected to slip in the first quarter, the U.S. economy still looks likely to continue its relative outperformance.
The good news for emerging market assets and commodity prices is that while unwinding a U.S. dollar-denominated loan now makes sense, the weakness of the Japanese economy gives traders an alternative source of funding, the Japanese yen.
That means that while the rise in the value of the dollar has temporarily unsettled commodities and emerging market stocks, it doesn’t mean an end to the cash flows that have supported prices of those assets over the past year.
And that says that what we’re seeing now is a correction rather than the end of the long-term trend in favor of commodities and emerging market equities.