Sujata Rao and Saikat Chatterjee

LONDON, (Reuters) – The race for the dollar to its two-decade-highs is leaving a trail that has caused a lot of damage. It’s increasing inflation in other countries as well as tightening financial markets at a time when the global economy faces the possibility of a slowdown.

The U.S. Federal Reserve’s decision to raise interest rates sooner than any other country is driving the 8% annual gain in a basket of currencies. It also aims to increase them faster, as it has historically been a safer haven for those experiencing turbulence.

The reluctance of Japan to change its ultra-easy policies and the fears of recession in Europe are also supporting it.

These are the areas that have been affected by dollar-flexing.

Graphic: FX returns this month – https://fingfx.thomsonreuters.com/gfx/mkt/zgpomlzrypd/Fx%20returns1.JPG

1/EXPORTS

Export-reliant countries like Japan and Europe are usually benefited by currency weakness, however this may change if inflation is rising or high.

The Eurozone inflation reached a new record of 7.5% in March, though the European Central Bank has not yet released a statement. However, policymakers have blamed it on high energy prices.

Haruhiko Kuroda, Bank of Japan chief, still sees yen weakness in Japan as a positive, however lawmakers worry that the 20-year lows of the yen will cause damage through higher fuel and food prices. A survey revealed that half of Japanese companies expect rising costs to affect earnings.

2. Tightening Becoming Frightening

The U.S. dollar’s rising value tends towards tightening financial conditions. These are a result of the available funding. Goldman Sachs (NYSE 🙂 believes that a 100 bps increase in the Financial Conditions Index (FCI), which is widely used by Goldman Sachs, would reduce growth by 1 percentage point over the next year.

FCI (which factors in dollar trade impact) shows that global conditions have been at their tightest level since 2009. As the dollar has strengthened 5%, the FCI tightened by 120 basispoints in April.

Particularly high amounts of dollars debt are common in emerging markets. The FCI report by Goldman shows that EM conditions are now at 190 basis points tighter than usual, with Russia leading the charge.

Since July 2020, the U.S. FCI has been at its most restrictive since that date.

It has to concern considering all that is going on. This is just the time you don’t want too much tightening of conditions,” said Justin Onuekwusi, portfolio manager at Legal & General Investment Management.

Graphic : Borrowing costs – https://fingfx.thomsonreuters.com/gfx/mkt/egvbkeqnzpq/borrowing%20costs.JPG

3: THE EMERGING QUESTION

Dollar strength was a key factor in almost all of the past crises that affected emerging markets. For example, a 10.5% increase in 1993 and a 4.6% increase in 1994 were both blamed for the “Tequila Crisis” in Mexico. This was followed up by meltdowns across emerging markets in Asia as well as Brazil, Russia, and Brazil.

For commodity exporting countries, a stronger dollar means more revenues in their local currency. However, higher servicing costs are the downside.

Fitch estimates that the median foreign-currency debt of emerging markets was a third to GDP at end-2021. This compares with 18% in 2013. Numerous developing countries already seek IMF/World Bank aid. Additional dollar strength could increase these numbers.

Graphic : Emerging market currencies – https://fingfx.thomsonreuters.com/gfx/mkt/klvyklbkevg/emerging%20FX.JPG

4. NO REFUND ON COMMODITIES

A firmer greenback will make dollar-denominated commodities more expensive for those who are using other currencies. This eventually leads to lower demand and lower prices.

Tight supplies of important commodities prevented this equation from happening. This is because the Ukraine-Russia conflict has affected exports oil, grains, and metals. It also kept the prices up.

Onuekwusi of LGIM stated that when you look at Eastern Europe’s current situation, the dollar cannot compete.

5/GOOD FOR FOED

Fed may welcome an increase in greenback to reduce import inflation. Societe Generale (OTC) believes that 10% of the dollar appreciation would result in U.S. consumer inflation falling by 0.5 percentage points per year.

The Fed will not need to tighten its monetary policy aggressively if dollar gains continue; in particular, money market bets regarding Fed rate increases have stabilized after the recent dollar surge.

Stephen Gallo, analyst at BMO Markets says that if the Fed’s trade-weighted broke above pandemic time highs (currently 2% below), “that could be enough for the Fed to give a less-hawkish increase next week.”

This could well be the pinnacle of the dollar, he said.

Graphic: Fed funds target rate and the dollar – https://fingfx.thomsonreuters.com/gfx/mkt/akvezynqdpr/Fedfundsand%20dollar.PNG