Hamartia Antidote
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https://www.marketwatch.com/amp/story/guid/7471D19C-6377-11E8-A018-3CBFBBB1E66B
Governments that have issued debt that’s denominated in dollars could be in serious trouble if the U.S. currency keeps rising
The U.S. dollar has been on a tear, staging the biggest rally since 2016. Some pundits claim this is only a bear-market bounce. However, the evidence suggests otherwise.
On March 24, I wrote via the Profit Radar Report that: “We are looking for a significant USD rally and EUR/USD EURUSD-0.3% decline in 2018.”
I expect this trend to continue, and eventually even to accelerate. Why and when is discussed here: U.S. dollar and euro outlook.
The law of unintended consequences
When viewed in isolation, a rally of the currency in which you’re paid (dollar) is a good thing.
But, as so often, there are unintended consequences. A classic (non-financial) example of unintended consequences is Australia’s cane toad problem.
In 1935, Australia imported cane toads in an attempt to control cane beetles. The problem is that cane toads are poisonous, can weigh more than 2 pounds and have no natural enemy.
Today, Australia has a cane toad problem, and doesn’t know how to get rid of it.
Could an ever-rising U.S. dollar become the “cane toad of the financial world”?
Reverse inflation trap
Governments issue debt for two reasons:
1. They need money
2. They know debt is worth more today than tomorrow.
Due to the eroding effect of inflation, governments only have to pay back cents for every dollar.
Here is where it gets interesting: Governments around the world can issue debt denominated in dollars.
For example, if Italy issued $1 million worth of debt (bonds) in February, that debt was worth 800,000 euros (assuming the EUR/USD rate of 1.25 in February).
If the U.S. dollar rallies, and the EUR/USD falls from 1.25 to 1, it would cost Italy 1 million euros to repay that debt.
A rising U.S. dollar will make it more costly for governments with U.S.-denominated debt to service their debt.
That could turn into a big problem for various European countries as they never properly disposed of their bad debt during the last financial crisis.
Ripple effects
The ripple effects of a rising U.S. dollar are hard to predict, but the 2008 financial crisis showed that contagion can spread much further than expected.
Nevertheless, a rising U.S. dollar does not have to be bad for U.S. equities. In fact, U.S. equities benefit as a perceived “safe haven” destination, which is in line with the multi-month S&P 500 SPX+1.08% outlook.
Governments that have issued debt that’s denominated in dollars could be in serious trouble if the U.S. currency keeps rising
The U.S. dollar has been on a tear, staging the biggest rally since 2016. Some pundits claim this is only a bear-market bounce. However, the evidence suggests otherwise.
On March 24, I wrote via the Profit Radar Report that: “We are looking for a significant USD rally and EUR/USD EURUSD-0.3% decline in 2018.”
I expect this trend to continue, and eventually even to accelerate. Why and when is discussed here: U.S. dollar and euro outlook.
The law of unintended consequences
When viewed in isolation, a rally of the currency in which you’re paid (dollar) is a good thing.
But, as so often, there are unintended consequences. A classic (non-financial) example of unintended consequences is Australia’s cane toad problem.
In 1935, Australia imported cane toads in an attempt to control cane beetles. The problem is that cane toads are poisonous, can weigh more than 2 pounds and have no natural enemy.
Today, Australia has a cane toad problem, and doesn’t know how to get rid of it.
Could an ever-rising U.S. dollar become the “cane toad of the financial world”?
Reverse inflation trap
Governments issue debt for two reasons:
1. They need money
2. They know debt is worth more today than tomorrow.
Due to the eroding effect of inflation, governments only have to pay back cents for every dollar.
Here is where it gets interesting: Governments around the world can issue debt denominated in dollars.
For example, if Italy issued $1 million worth of debt (bonds) in February, that debt was worth 800,000 euros (assuming the EUR/USD rate of 1.25 in February).
If the U.S. dollar rallies, and the EUR/USD falls from 1.25 to 1, it would cost Italy 1 million euros to repay that debt.
A rising U.S. dollar will make it more costly for governments with U.S.-denominated debt to service their debt.
That could turn into a big problem for various European countries as they never properly disposed of their bad debt during the last financial crisis.
Ripple effects
The ripple effects of a rising U.S. dollar are hard to predict, but the 2008 financial crisis showed that contagion can spread much further than expected.
Nevertheless, a rising U.S. dollar does not have to be bad for U.S. equities. In fact, U.S. equities benefit as a perceived “safe haven” destination, which is in line with the multi-month S&P 500 SPX+1.08% outlook.
