Global financial markets have been hit with a bout of volatility in the past few weeks, shaken by the prospect of an escalation of the U.S. – China trade war and an economic slowdown. Oil prices have gyrated on the news.
Even as the markets have steadied a bit, and the U.S. mulls ways to de-escalate the trade war, the recent strengthening of the U.S. dollar – which is not unrelated to the market selloff – remains a headwind for both crude oil and for the health of the global economy.
Dollar strength looms over financial markets
President Trump’s announcement that the U.S. would impose another round of tariffs on China beginning in September was the proximate cause of recent flare-up of financial and economic concerns, but the slowdown has been unfolding for quite some time. In late July, the U.S. Federal Reserve cut interest rates for the first time since the global financial crisis a decade ago, a dramatic U-turn from the rate hikes seen over the last few years and an admission that economic cracks were becoming more apparent.
An interest rate cut would normally lead to a depreciation of the dollar, but markets had largely baked in a reduction into their baseline assumptions. In fact, Fed Chairman Jerome Powell’s press remarks about how everyone should not assume the central bank was embarking upon an extended period of rate cutting led to disappointment. Instead of a jolt, the action and the comments allowed economic concerns to fester.
President Trump announced a proposed tariff increase on $300 billion worth of Chinese imports, a move that caused oil prices to plunge by more than 7 percent in a single day
Only a day later, President Trump announced a proposed tariff increase on $300 billion worth of Chinese imports, a move that caused oil prices to plunge by more than 7 percent in a single day amid heightened concerns about a global economic recession. In the following days, sensing the fallout, the Trump administration delayed at least some of the tariffs until the end of the year.
However, the trade war has contributed to turmoil in currency markets that may be difficult to undo. Despite the Fed rate cut and the tariff announcement, the dollar strengthened. Just as important was the fact that China allowed its currency to weaken in order to offset some of the damage from American tariffs. The yuan weakened to about 7 to 1 to the dollar, its weakest point since before the global financial crisis in 2008.
China’s yuan is a critically important currency to global economy, and its depreciation produced ripple effects in short order. A few days after the yuan was allowed to weaken, a cascade of interest rate cuts cropped up around the world. The central banks of New Zealand, India and Thailand all cut their rates in an attempt to head off a dangerous appreciation of their currencies relative to the yuan. Currencies are interconnected, so a move by one causes gyrations in others. In this sense, central banks around the world have no choice but to react to decisions made in Washington and Beijing as the trade war marches on. On August 15, Mexico’s central bank lowered its interest rate.
Roughly 30 countries have cut interest rates this year. The last time that so many central banks cut their rates or considered some version of monetary stimulus was in the midst of the global financial crisis a decade ago, according to the New York Times, citing data from Refinitiv.
As governments scramble to weaken their currencies, one after the other, the dollar strengthens further
As governments scramble to weaken their currencies, one after the other, the dollar strengthens further. The ICE Dollar Index is up 11 percent since early 2018.
There is a self-reinforcing aspect to the currency maneuvers. As other currencies depreciate, they become less attractive to investors, who flee into the U.S. dollar for safety, thereby strengthening the greenback further. This dynamic means that the dollar can see upward pressure amid, and even because of, financial uncertainty.
While a strong dollar is not uniformly a bad thing, it is a major obstacle to U.S. exporters. It is also a serious headwind to companies, consumers and governments around the world, who face more expensive dollar-denominated debt. As emerging markets come under pressure, their currencies can see yet more downward pressure. “The escalation in trade tensions following the sharp [yuan] devaluation increases downside risks to the mild recovery in activity that we expect in 2H19,” Goldman Sachs wrote in a note on August 7.
Ultimately, the U.S. Federal Reserve is now under intense pressure, and may be forced to cut interest rates again. That is especially true as China has allowed the yuan to weaken since the Fed’s last action a few weeks ago.
Moreover, if and when tariffs go into effect, China’s currency will face further headwinds. If the yuan weakens even more relative to the dollar, perhaps significantly past the 7:1 ratio, it “would lead to another bout of volatility locally as corporates and investors have generally assumed that this level will hold and would have to adjust their hedges,” Bank of America Merrill Lynch wrote in a note. “On the heels there would also likely be angry ‘currency war’ rhetoric from Washington.” Financial markets are already showing signs of being “nervous about this,” BofA said.
Crude oil, which is priced in dollars (along with a whole host of other commodities), becomes significantly more expensive when the dollar strengthens. That cuts into demand and ultimately pushes down crude prices. The problem for oil is that demand has already weakened significantly, with repeated downward revisions by the major energy forecasters. The International Energy Agency slashed its demand growth forecast once again to 1.1 million barrels per day for 2019, a figure that could turn out to be overly optimistic given the looming trade war escalation and ongoing currency volatility.