There may be another explanation for stock market volatility: a more expensive US dollar

The consensus view that recent market upheaval is just a correction may yet prove to be right, but the risk is that it is just wishful thinking

PUBLISHED : Tuesday, 13 February, 2018, 10:51am
UPDATED : Tuesday, 13 February, 2018, 10:34pm

Certainly the sell-off in US equity markets followed the February 2 release of US average hourly earnings data which showed a 2.9 per cent year-on-year rise in January, the biggest increase since June 2009. Wednesday’s US consumer price index (CPI) release arguably now assumes even greater importance than usual.

A benign CPI reading, especially if reinforced by Thursday’s US producer price index (PPI) number, may calm nerves. Equity markets could then consolidate, US Treasury yields could ease and prior currency market trends could reassert themselves.

Of course, above-forecast US CPI and/or PPI prints might reignite turbulence.

Either way there are valid questions as to why markets suddenly got the jitters about a potential rise in US inflation when US President Donald Trump’s policy agenda was always fiscally expansive and, with the United States at near full employment, could foster a degree of inflation.

An alternative explanation might be that the fall in US equity markets, though ostensibly triggered by markets taking fright at an elevated hourly earnings print, is actually a by-product of global monetary policy settings that have already become less accommodative. In which case further monetary tightening might only make matters worse.

Janus Henderson’s Simon Ward argued last Thursday that market prospects “are related to the difference – if any – between actual growth in the stock of money and the rate of expansion warranted by (nominal) economic expansion.”

Where there is ‘excess’ money growth, Ward asserts that “will usually be associated with an increase in demand for financial assets and higher prices of those assets – assuming unchanged supply. Conversely, low money growth relative to economic needs will usually signal weak demand for assets and stagnant or falling markets.”

On February 5, Ward had already postulated that “six-month growth of real narrow money in the G7 and seven large emerging economies fell to its lowest level since 2009 in December,” concluding “the global economy will slow significantly later in 2018.”

Quantitative easing (QE) programmes across a number of major economies in the years following the global financial crisis did create a pool of excess money growth and financial asset prices did rally. US QE also weighed on the value of the US dollar as lower yields in the United States prompted capital outflows from the US dollar in pursuit of better returns.

But US QE has now been replaced by a measured scaling back of asset purchases. QE has given way to quantitative tightening (QT), even as the Federal Reserve has been raising benchmark rates. The price to borrow US dollars has been rising at the same time as QT is quietly eating into the degree of availability of the dollar.

This is occurring even as December’s enacted US tax legislation encourages US companies to repatriate dollars held offshore. Repatriating offshore dollars is bound to push up the price for accessing US dollar liquidity outside the United States.

US banks, as likely recipients of repatriated dollars, are not charities and will demand a price for lending those dollars back into the global market. And that’s assuming of course those dollars aren’t gobbled up by Uncle Sam whose own borrowing requirements will balloon following Friday’s passage of a new federal budget.

Meanwhile, the tax legislation, by boosting US workers’ take-home pay, should promote US domestic consumption, potentially adding to any emerging upwards pressure on inflation and attracting the attention of the Federal Reserve.

US quantitative tightening, Fed rate rises and Trump administration policies could combine both to reduce the availability of US dollars in the global financial system and simultaneously raise the price for borrowing dollars.

As market trends of recent years have rested on a foundation of access to huge volumes of very cheap US dollars, if such a scenario unfolds it could have serious consequences.

Equity markets, rather than consolidating after the recent and, for many, painful correction, could continue to drop. US Treasury yields, rather than popping higher, might steady or fall as safe haven demand for US government paper pushes up Treasury prices. On the currency markets, the US dollar, rather than recommencing its recent fall, might continue to strengthen.

The consensus view that recent market volatility is just a correction may yet prove to have been right. The risk is that it is just wishful thinking.