The Breakdown - The Dollar Is Our Currency and Your Problem

Episode Date: September 28, 2022

This episode is sponsored by Nexo.io, Chainalysis and FTX US.    The joke du jour on FinTwit has been that the British pound is trading like an emerging market currency (or on Crypto Twitter, like a s**tcoin). On today’s episode NLW looks at what’s happening and why dollar strength is wreaking havoc around the world.  - Nexo is a security-first platform where you can buy, exchange and borrow against your crypto. The company ensures the safety of your funds by employing five key fundamentals including real-time auditing and recently increased $775 million insurance on custodial assets. Learn more at nexo.io. - Chainalysis is the blockchain data platform. We provide data, software, services and research to government agencies, exchanges, financial institutions and insurance and cybersecurity companies. Our data powers investigation, compliance and market intelligence software that has been used to solve some of the world’s most high-profile criminal cases. For more information, visit www.chainalysis.com. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - I.D.E.A.S. 2022 by CoinDesk facilitates capital flow and market growth by connecting the digital economy with traditional finance through the presenter’s mainstage, capital allocation meeting rooms and sponsor expo floor. Use code BREAKDOWN20 for 20% off the General Pass. Learn more and register at coindesk.com/ideas. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is “Razor Red” by Sam Barsh and “The Life We Had” by Moments. Image credit: John M Lund Photography Inc/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

In total, the Dixie has moved more than 20% so far this year. Of the major financial crises over the last 30 years, only the global financial crisis in the 2015-U-Wan devaluation have featured a more serious spike in the Dixie, although in general major crises are associated with dollar strength as people flood to what they perceive to be the safest currency. However, a major difference this time around is the lack of interest from U.S. policymakers in taming the strong dollar. Welcome back to the breakdown.

with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.i.o, chain aliasis, and FtX. And produced and distributed by CoinDesk. What's going on, guys?

It is Tuesday, September 27th, and today we are discussing why for the rest of the world the dollar is our currency and their problem. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it,

give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also a disclosure, as always, in addition to them being a sponsor of the show, I also work with FTX. All right, folks, I am excited for this show today. I mentioned yesterday that Sunday night saw some serious fireworks around the pound in the UK. That continued into Monday, and what's more, the British pound isn't the only major current to have issues recently. Last week, as we'll see, the Japanese yen also had a rough run of it. Joe Wisenthal from Bloomberg noted on Monday that every major currency in the world was down

against the dollar. Headlines are blaring that big problems are brewing, such as this one from Bloomberg, which says, Morgan Stanley says dollar surge tends to end in crisis. So today we're exploring what the hell is going on in global currency markets and what the dollar wrecking ball might have in its path. Following the most hawkish FOMC meeting for the year, and a fresh commitment from the Federal Reserve to go full Volker, the dollar has begun another round of strengthening. The DXY, or Dixie, is an index of dollar strength against a basket of developed nation currencies. Over the weekend, the Dixie moved up more than 2.5%, which is an absolutely gigantic swing for currency markets. Interestingly, unlike previous large moves in the dollar this year,

we're beginning to see countries take action to protect their currencies and their economies. On September 24th, Jim Bianco wrote, the U.S. economy is about 25% of world GDP, but thanks to the dollar's reserve currency status, or exorbitant privilege, about 85% of the world's trade is priced in dollars. The dollar's surge is putting enormous stress on global trade as the benchmark devalues their local currencies. The reason that the dollar strengthening can be so problematic

for countries that are, for example, net importers of key goods, supplies, etc., is that when prices are denominated in dollars, and those dollars are more expensive than they used to be, that means it takes more of the local currency to buy the same goods. So the price of the dollar going up can have severe ramifications for those countries, which have to import and pay for a lot of the stuff that they need in dollars. Anyways, this idea that countries are now starting to defend their currencies and economies suggest that a global pain threshold for dollar strength, might have been reached. In total, the Dixie has moved more than 20% so far this year. Of the major financial crises over the last 30 years, only the global financial crisis in the 2015-Uan

devaluation have featured a more serious spike in the Dixie, although in general major crises are associated with dollar strength as people flood to what they perceive to be the safest currency. However, a major difference this time around is the lack of interest from U.S. policymakers in taming the strong dollar. In the past, there's always been a sense that it's important for the U.S. to make sure that the dollar doesn't get too strong. Viraj Patel, a strategist at Vanda Research, said, this time, however, there is, quote, close to zero percent probability on the Treasury intervening right now to weaken the dollar. Comparisons are being drawn to the early 1980s, where the fallout from the Volker shock

resulted in five years of nearly continuous strengthening in the dollar. This ultimately led to the Plaza Accord in 1985, where developed nations came together to agree to mutually devalue the dollar against other global currencies. However, right, now, with a strong dollar aligning with the U.S. national interest in taming domestic inflation and funding an onshoreing or reshoring effort, it's hard to imagine that level of global cooperation coming anytime soon. Jean-Charles Grand, the chief technical analyst at market securities, writes, it's every country for itself in the battle against the dollar. Japan's foray into the FX fray put it in company with nations from India to Chile

that have been tapping their stockpiles to fight the mighty greenback. The situation is reminiscent of the 1980s, but the chance of a plaza accord like pact to attack the problem is remote. Prathamish Goodball wrote, The last time we saw such a massive dollar rally was in the 1980s, when so high it crushed American business. The overseas percentage of earnings for U.S. today is higher. Assuming the Fed stops hiking in December, we'll see another Plaza Accord later and start of a big boom late 2023, early 2024. Now that, of course, makes the assumption that the Fed stops hiking, which it isn't at all clear that they're going to

do, at least from their rhetoric right now. Preston Pish argues that a new Plaza Accord might not even solve things. A new The new Plaza Accord doesn't fix the fiscal addiction that net importers have. They can rig their currencies as much they want amongst themselves, but it sure doesn't have to convince net exporters to accept their paper promises that must be aggressively debased from here. Now, there is a remarkable chart from Bloomberg and Morgan Stanley research that charts year-over-year changes in the Dixie with major financial issues. Each time there is a year-over-year spike in the Dixie, there is an accompanying crisis going back to the early 1990s. In the last 20 years, that's included the tech

bubble in 2000, the housing bubble peak in 0506, the global financial crisis in 0809, Europe's sovereign debt crisis in 2012, China's devaluation and global recession in 2015-2016, and a big old question mark for this year. But let's turn now to some of the places where this challenge is manifesting, starting with the most recent notable of the UK. On Friday, newly appointed finance minister Kwasi QWERTing delivered a mini-budget which will seek to drive economic growth via tax cuts. With unbearably high energy costs, the main issue to be dealt with in the UK, minister asserted that, quote, the prime minister has acted with great speed to announce one of the most significant interventions the British state has ever made. And the interventions were dramatic,

with commentators either praising the budget as a return to Milton Freeman-inspired economics, or rather than representing the worst of zombie regonomics or Thatcherism. The headline policy was the removal of the top tax bracket, meaning that the wealthiest citizens would see a huge reduction in tax. Someone earning a million pound salary will receive, for example, an additional 55,000 pounds in tax savings. Quarting said, high tax rates damage Britain's competitiveness. They reduce the incentive to work, invest, and start a business. And the higher the tax, the more ways people seek to avoid them, or work elsewhere or simply work less, rather than putting their time and money to more creative and productive ends.

All told, this is the largest UK tax cut since 1972, delivering 45 billion pounds worth of cuts. Conservative media was jubilant at the prospect of a turbocharged tax cut. Alistair Heath at the Daily Telegraph said, this was the best budget I had ever heard a British chancellor deliver. The tax cuts were so huge and bold, the language so extraordinary. that at times I had to pinch myself to make sure I wasn't dreaming, that I hadn't been transported to a distant land that actually believed in the economics of Milton Friedman and F.A. Hayek. Others were more concerned about the risks to the nation inherent in such a dramatic tax cut policy. Martin Wolf of the Financial Times said this will do nigh on nothing to raise medium-term growth,

but risks serious macroeconomic instability. The failure to ask the office for budget responsibility to assess its impact is simply scandalous. This government may be indifferent to painful reality, but reality usually wins in the end. The taily mirror went farther, saying, short of burning 50-pound notes in front of the poor, Quartan could not have delivered a more insulting budget. His plans are economically incoherent, fundamentally unequal, and fiscally dangerous.

Markets rendered their verdict immediately, with the pound collapsing 3.5% on Friday. This is one of the five largest intraday moves in decades, hitting levels not seen since 1985, and a new all-time low against the dollar. As the tax cut is meant to be funded out of deficit spending, leading to much greater issuance of sovereign bonds, the UK bond market also sold off as well. Two-year yields hit their highest level since 2007, and 10-year yields rose to levels not seen since 2010.

Many analysts were skeptical that the UK will even be able to carry this plan out. City analysts said in a research note, quote, We think the UK will find it increasingly difficult to finance this deficit amidst such a deteriorating economic backdrop. Something has to give, and that something will eventually be a much lower exchange rate. Jane Foley, a senior foreign exchange strategist at Dutch Bank Robo Bank, wrote, The obvious implication is that BOE rates are likely to be higher for longer than they would have been otherwise. While textbooks suggest that higher short-term interest rates should be currency supportive, GVP has been demonstrating since the spring that this is not always the case.

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When you trade NFTs on FTCX, you pay no gas fees. Download the FtX app today and use Referral Code Breakdown to support the show. Fin Tuit had quite a bit to say about this as well. Matthew C. Klein of the Overshoot wrote, as enjoyable as it is to make fun of the UK, I'm not sure it's fair to characterize a tax package that mostly lowers rates for entities with low marginal propensities to consume as inflationary. Dario Perkins, the managing director of global macro at T.S. Lombard, responded, saying the problem isn't that the UK budget was inflationary, it's that it was

moronic. And a small open economy that seems to be run by morons gets a wider risk premium on its assets. Currency down yields up. Livercoin pointed out that the GDP was down 9% in three trading days, reminding FYI, even COVID flash crash was slower. And Sven Henrik wrote, I once considered moving to a developing economy, but decided 10% inflation and a 20% currency collapse was too unstable. So I decided to move to the UK instead. Jokes on me. Now all of this continued into Monday. Dario Perkins again talking about the Bank of England's options said, one, say and do nothing look clueless or asleep at the wheel. Two, say something but do nothing look toothless. Three, do something small, 50 basis points. Market will push you to do more,

perhaps quickly. Four, do something big. If this doesn't work, you're in a worse position than one. Arthur Hayes made the same emerging market joke saying, I love emerging markets, so much opportunity. Guess I'll be moving to London. And this trading like an emerging market idea actually got some traction, with Bloomberg's Tracy Allaway writing a piece called exactly that. She quotes a Deutsche Bank strategist who said, it is extremely unusual for a developed market currency to weaken at the same time as yields are rising sharply. But this is exactly what has happened since the new Chancellor's announcement. We worry that investor confidence in the UK's external sustainability is being eroded fast. Zero Hedge quoted a Sky News headline saying, Bank of England expected to make a statement today,

adding, and say what? We give up? And indeed, the Bank of England's statement was not necessarily super inspiring. One of the lines they chose to share as a photo was, we are in the process of communicating with relevant parties and fully committed to working this out. Now, all that said, not everyone was dunking. Paul Krugman wrote about this over the weekend, saying, thinking more about the reactions to the trust Quartang not a budget released Friday. While I yield to nobody in my disdain for their embrace of zombie economics, I'm puzzled by all the talk of a looming sterling crisis.

Since the 1990s, most currency crises have involved balance sheet effects. A country, either public or private sector or both, has large external liabilities in foreign currency. In that case, depreciation worsens balance sheets creating a self-fetched. reinforcing downward spiral. This was the story for Asia in the 1990s and the Argentine crisis 2001, part of the problem in Turkey now. But while the UK has a lot of external liabilities, they're overwhelmingly sterling denominated. The UK also has external assets largely direct investment. The result is that sterling depreciation actually improves Britain's net international

investment position. So a balance sheet currency crisis story doesn't seem to make sense. The other way you can have a currency crisis is if markets believe that you can't or won't service your public debt and will monetize it instead. This was the story behind the 1926-Frank crisis, and I think the 1976 sterling crisis which needs revisiting. But the Bank of England is independent these days and unlikely to monetize debt. And despite everything, UK debt isn't that high by long-run standards. So why did zombie regonomics produce currency depreciation, not the excessively strong currency caused by the original version? Well, it did say bad things about the competence of the new government. But at a guess, the moron risk premium has now been priced in. I guess I don't see the

mechanism for a continued sterling crisis. What am I missing? Interestingly, Tyler Cowan wrote about this in Bloomberg as well, with a piece titled, Trust's Economic Plan isn't the disaster everyone says it is, and despite coming from a very different political and economic perspective than Krugman agreed on much. He starts by quoting a swath of well-known economists. Larry Summers noted, I think Britain will be remembered for having pursued the worst macroeconomic policies of any major country in a long time. William Buter described it as totally, totally nuts. As Jason Furman summed it up, I've rarely seen an economic policy that isn't uniformly panned by economic experts in financial markets. However, Cowan wasn't buying this. First, he, quote, sees no evidence that the markets are beginning to doubt the

UK's ability to repay their debts, end quote. And what's more, he doesn't see the UK's level of debt is particularly high. Two, he thinks that fair criticism of the Bank of England is getting mashed together with this new government, writing, yes, nominal interest rates rose and the pound fell following the announcement of trust's policies, but the guilty party here is probably the Bank of England. If fiscal policy is expansionary, it is the duty of the central bank to offset that influence and tighten more on the monetary side. The bank has been slow to respond to inflationary pressures, for which it has been fairly criticized. Nonetheless, that is distinct from criticizing Truss's policies. Those policies do reveal a lack of coordination with the Bank of England, and that embarrasses the UK government. Still, it's not

clear that those costs will endure, or that a Democratic government should relegate its policy to that of the central bank. Most of all, however, Cowan points out the context. Quote, it is important to keep the falling pound in perspective. The dollar has been soaring against the currencies of such well-run countries as Japan and South Korea. Japan does not even have exorbitant rates of price inflation. The euro has fallen well below one-to-one parity with the dollar. Even if the UK continues to see its currency fall, by no means is this entirely explained by the developments on the British side of the ledger. Speaking of Japan, let's shift our attention there for just a minute. Last week, a bunch of central banks followed the U.S.'s lead and raised rates. The Bank of England

delivered its second straight 50 basis point hike. The Swiss National Bank also lifted its borrowing costs by 75 basis points, which is the first time they've exited negative rate policy since implementing it in December 2014. And the Bank of Japan continued its streak of six years without an interest rate movement and 23 years of near zero rates on Thursday. They decided to maintain negative rates of 0.1%, becoming the only major central bank still continuing with zero interest rate policy. Governor Corota said, I believe we won't be introducing a rate hike anytime soon. We've decided to continue the monetary easing after thoroughly discussing what the most effective monetary policy is by analyzing the Japanese economy, price trends, and future developments in depth.

Japan is experiencing 3% inflation currently, which is its highest level in 8 years. On news of the BOJ's decision, the yen crashed precipitously. It dropped almost a full percentage point in one day to hit 145 yen per dollar. That's the weakest exchange rate dating back to August 1998. The collapse of the yen then triggered direct intervention in markets by the Treasury for the first time since 1998, when the intervention was to combat a rapidly strengthening yen. The country's finance minister said on Thursday, in principle, exchange rates should be decided in the markets, but we cannot tolerate repeated rapid fluctuations by speculative moves.

Japan's prime minister also announced on Thursday that Japan would take advantage of the depreciation of the yen by reducing border control measures to welcome more tourists next month, doing away with arrival caps, and granting visa waivers to more than 70 countries. Now, all of this leaves us in a place where the coordinated tightening of monetary policy has been conceptualized by some as a reverse currency war, where central banks compete to support their currencies and push inflation offshore. Mark Dow commented on this paraphrasing Vizini from the Princess Bride, You've fallen for one of the two classic blunders. The first being never get involved in a currency war in Asia, but only slightly lesser known, never go in against the Fed when debt is on the

line. Vinson DeLard wrote, The currency wars of the early 2010s were about weakening currencies to steal one's neighbors' demand. The currency wars of the early 2020s are about strengthening currencies to steal one's neighbor's supply. And through all of this, the dollar just keeps rising. Joe Wisenthal reshared a chart from John Turek called the dollar doom loop. Stronger dollar leads to lower global manufacturing, leads to lower commodity prices, leads to lower global trade, leads to worries about growth, leads back to a stronger dollar. Will Clemente, watching all of this said, these currency moves are insane. Things are breaking. And isn't that exactly what the Fed said it was going to be looking for in terms of changing its policy?

Well, Tracy Allo-A sort of nailed it when she tweeted, going to have to start caveating hike until something breaks with hike until something American breaks. This, of course, harkens back to a famous quote from Richard Nixon's Treasury Secretary John Connolly in 1971. The dollar is our currency, but it's your problem.

Later this week, we'll be exploring whether things are in fact breaking, or, as some, like Jim Bianco contends, the problem is that they are actually not. For now, I want to say thanks again to my sponsors, nexus.com.com, and thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.

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