Why The Rising U.S. Dollar Could Destabilize The Global Financial System

Tyler Durden's picture

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

I have been suggesting for several years that the U.S. Dollar would confound those anticipating its demise by starting a long secular uptrend.

In early September I made the case for a rising U.S. dollar, based on the basic supply and demand for dollars stemming from four dynamics:
  1. Demand for dollars as reserves
  2. Other nations devaluing their own currencies to increase exports
  3. “Flight to safety” from periphery currencies to the reserve currencies
  4. Reduced issuance of dollars due to declining U.S. fiscal deficits and the end of QE (quantitative easing)
Since then the dollar has continued its advance, and is now breaking out of a downtrend stretching back to 2005—and by some accounts, to 1985:



Technically, the Dollar Index has broken out of a multi-year wedge:

So what does this mean for the global economy?

Since currencies are intertwined with virtually every aspect of the global economy—trade, credit, inflation/deflation, commodities and capital flows, even political and soft power—there is no one consequence, but a multitude of interactive consequences.
For U.S. households, the rising dollar will have gradual, generally marginal effects: our dollars will buy more euros and yen when we visit Europe and Japan as tourists, imports from countries with weakening currencies will be slightly cheaper (if the importers don’t palm the difference as extra profit) and we may be competing with more foreigners for dollar-based assets such as American homes, oil wells and Treasury bonds.
In sum, a rising dollar will only affect households on the margins. Since roughly 85% of the U.S. economy is domestic, imports and exports have relatively limited influence on the entire economy.
In other words, the direct consequences of a stronger dollar on U.S. households are generally positive, with the exception of those working in price-sensitive export industries, where the rising dollar will make goods sold in countries with weakening currencies more costly.
But the secondary effects could end up being far more consequential for Americans and everyone else on the planet, for this reason: the centrality of the dollar in the global economy means that the effects of a stronger dollar can create potentially destabilizing dynamics. 
Simply put, the dollar's rise could destabilize the entire global financial system. To understand why this is so, we have to start with the source of the risk: the world's central banks.

Central Banks Are Responsible for the Heightened Risk

One primary reason for this expansion of risk is the unprecedented actions of the world’s central banks since the 2008 Global Financial Meltdown. In effect, the central banks doubled down on debt and leverage as the politically expedient “solution” to the implosion of credit and leverage (what we call de-leveraging) as the collateral underlying highly leveraged loans (think subprime mortgages on overpriced McMansions) evaporated like mist in Death Valley.
Any solution that forced the write-down or write-off of the mountain of bad debt would have collapsed the over-leveraged banks which had become linchpins in the global financial system.
So the only way to maintain the status quo and avoid handing massive losses of wealth to financial elites was to issue trillions of dollars in new credit-money, lower interest rates to near zero and start buying assets from private-sector owners, turning their assets into cash that could then be used to invest overseas or in domestic stocks and bonds.
Each major central bank injected unprecedented sums of new money into their economies to ease the refinancing of debt at lower interest rates and enable expansion of credit for new loans.
If each economy (or in the case of the European Union, currency region) was moated by strict capital-control regulations, this massive goosing of credit might have been contained within each economy.
But in today’s world of digital finance, capital, credit, risk and interest rates all flow wherever the risk is perceived to be controllable and the return is greatest.
Let’s pause for a moment to recall that risk in 2008 was perceived to be controllable right up until the day that Lehman Brothers declared bankruptcy and the global financial system erupted in a fireball of panic and liquidation.
Why was risk considered controllable right up to the implosion? Derivatives and hedges were widely assumed to be solid protection against any spot of bother in global credit markets. But this confidence was misplaced, as it ultimately relied on multiple counterparties retaining their solvency. 

 If a position was hedged by a derivative that was to be paid by a counterparty if things went south, and the counterparty blew up before the hedge could be paid off, there was no hedge.

It turned out that liquidity—a market of buyers and sellers that allows any security to be sold more or less whenever the seller decides to sell—dried up, and markets for risky securities went bidless, i.e. there were no buyers at any price.
If there are no buyers, the value of the security drops to zero, and everybody down the line who counted on that security fetching the anticipated price so their hedge could be paid off also implodes.
Central banks countered this implosion by buying bonds and mortgages and lowering interest rates so old debt could be refinanced at much lower costs.
But in doing so, they created a vast market for global carry trades—the borrowing and buying of assets in various currencies to take advantage of yield and interest-rate differences.   In the old pre-digital days, it was difficult to arbitrage these variations in national currencies and interest rates. But in today’s world, it’s easy for financiers and financial institutions to borrow money in dollars or yen at low interest rates and re-invest the money in higher-yield securities issued in other countries.

The Problem with Carry Trades and Cross-National Debt

The central bank’s massive issuance of new money put trillions of dollars in the carry trade, and this vast expansion of global currency/interest-rate arbitrage has put currency values front and center.
The carry trade simply means cheap-to-borrow money in the US and Japan flows to emerging markets where rates are higher.  If you can borrow $1 billion at a 0.25% rate in the U.S. or Japan and then buy emerging-market bonds that pay much higher yields, why not?  The profit is free money.
The sums of money being gambled in carry trades are enormous. It is estimated that $7 trillion of emerging market debt is denominated in another currency. According to the Telegraph newspaper (U.K.), roughly two thirds of the $11 trillion in cross-national loans are denominated in U.S. dollars.
$11 trillion may not seem like much when compared to America’s $16 trillion gross domestic product (GDP), but the emerging markets which have been the happy recipients of this vast river of capital have much smaller economies and credit markets.
They also have fewer options to refinance debt, as they lack heavyweight central banks like the Bank of Japan, the European Central Bank and the Federal Reserve.
As a result, these capital flows are extremely consequential and thus potentially disruptive.
Here’s the risk in carry trades: if the currency you borrowed the money in strengthens and the currency you’re receiving the interest payments in weakens, the deal sours. The rise and fall in currencies can erase the profits of the carry trade.
If the currencies weaken/strengthen beyond break-even, a once-profitable trade turns into a losing trade.
And how do you extricate yourself from the carry trade? You sell the emerging-market assets and repatriate the money back into the currency you borrowed the money in: for example, the U.S. dollar.
This has immediate supply-demand effects on currencies. The emerging-market currency that’s being sold drops in value while the currency that’s in demand (U.S. dollars) strengthens.
We might imagine that the Federal Reserve ending its vast money-issuance program of quantitative easing would lessen the global risk posed by the carry trade, as it reduces the flood of dollars seeking higher-yield homes outside the U.S.
But this tightening has actually increased the risk of carry trades blowing up and bringing down emerging-market economies, for it reduces the flow of fresh capital into emerging markets.  As the supply of dollars dries up, demand for dollars rises as carry trades are unwound.  Emerging-market currencies then weaken significantly, causing profitable carry trades to reverse into losing trades, which then causes those holding debt in dollars and assets in other currencies to dump the assets and pay off the dollar-denominated debts before the trade goes even more against them.
There is a positive feedback in play: the more the dollar rises, the greater the losses in carry trades denominated in the dollar, and the greater the incentive for those still in the trade to sell emerging market assets and currencies.
In response to these massive outflows of capital, emerging nations must raise interest rates quickly to offer incentives for capital to stay put, which then causes the cost of new loans (and doing business in general) to quickly rise to painful levels.
As the currencies suffering outflows decline against the dollar, imports become more expensive and exports lose value when traded for dollars. It’s a triple-whammy for emerging nations: their borrowing costs are soaring, the capital leaving to pay off dollar-denominate debt leaves them starved for investment capital, and their imports rise in cost as their exports earn less.
So here is the net result of central banks pursuing quantitative easing and zero-interest rates: a massive increase in global risks resulting from the carry trades the money expansion and cheap rates fueled.
The central banks’ “solution” has blown another global bubble of risk that now threatens to destabilize not just the carry trades but the economies and credit systems that have become intertwined with the carry trade.
In effect, the failure to address the structural problems revealed in the Global Financial Meltdown of 2008-2009 have been transferred to the larger foreign-exchange (FX) market, which is connected to virtually everything in the global economy.
In Part 2: Why The Strengthening Dollar Is A Sign Of The Next Global Crisis, we examine these risks to the global economy. Not only is a rising dollar a sign of weakness elsewhere in the world, but the higher it rises, the more destabilizing global currency imbalances become. If it rises too high, it then becomes a cause of further destabilization -- one that could trigger the next global crisis. 

Click here to access Part 2 of this report (free executive summary; enrollment required for full access)


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kliguy38's picture

Look at the backwardation in gold......something is about to collapse

Groundhog Day's picture

Maybe thats the plan all along.  strong dollar destabilizes the world.  rothschilds step in with SDR's so this never happens again...haha...the humanity.. 

I see you rothschild.. i see your tricks

Vampyroteuthis infernalis's picture

The CBs have made their own filth lined beds, they can sleep in the beds. 

philipat's picture

The REAL potential problem is with Derivatives if the Dollar keeps increasing.

Groundhog Day's picture

Maybe thats the plan all along.  strong dollar destabilizes the world.  rothschilds step in with SDR's so this never happens again...haha...the humanity.. 

I see you rothschild.. i see your tricks

max2205's picture

THe reason isnegative rates in the EU.....what did they expect.....dumb idiots


EU capital controls next...wait and see....we will charge You interest and you can't move your money

walküre's picture

real estate reality in Germany

seller receives 200k Euro for house

bank issues 241k in mortgage debt to buyer to pay for house and renos

where have we seen this movie before?

MalteseFalcon's picture

The rising dollar is an unmitigated good thing for the vast majority of Americans

in4mayshun's picture

I'll be sure to remember that while were getting cooked by Fukashima, poisoned by GMO's, beaten by our police force and robbed by our Government.

Oh thank God for a strengthening dollar!

LawsofPhysics's picture

Should read "Why the majority of the earth's population dropping the use of the dollar could be bad..."

Herd Redirection Committee's picture

Yep, those dollars will have to come home at some point.

All those coke-lined $100 dollar bills...

Glass Seagull's picture



Fed is the biggest USD short seller.  Capiche?

1000yrdstare's picture

Rise or fall, does not matter.... the 1% will be fine, The rest....not so much..


go long sustainable (small) communities.

and fuck the rest of the Global world...

KnuckleDragger-X's picture

No matter which way it goes it will destabilize somebody and the CB's will make sure it's in the worst possible way.

ebworthen's picture

God forbid the carry trade profit is put at risk!

Central Banks = Moral Hazard.

Conax's picture

They had to pump the dollar or people might just try to take delivery of PM futures.

Now they have a problem with the pumped 'dollar'.  Too funny.

Send in the clowns on MSNBC, maybe they can talk it down a few pips.

rejected's picture

Bitch about the dollars loss of buying power then bitch about the dollars increase in buying power. LOL

The9thDoctor's picture

Bitch about the dollars loss of buying power then bitch about the dollars increase in buying power. LOL

You get every possible bear scenario here on Zero Hedge.

Vampyroteuthis infernalis's picture

Deflation is taking hold slowly. When defaults start accelerating, watch out. Prepare for the great printfest from the Fed at that point to inflate the dollar to a worthless state.

Winston of Oceania's picture

You may see the Treasury print in that manner but a bank will never print so many notes so as to ruin itself. Hyperinflation is a political event that governments employ to erase unpayable debt. The issuer of that debt, the bank, is who takes the loss in that case.

LawsofPhysics's picture

Unfortunately that "increase in purchasing power" you are refering to doesn't seem to apply to everything... (i.e. healthcare, education, utility bills... etc.)


the cognative dissonance of the world is mind boggling.

deadelephant's picture

NOtice anything about those three industries you just listed?  How about massive federal regulation.  Deregulate and the price of those comes down along with everything else.

LawsofPhysics's picture

So, regulation is bad?  Personally I thought Glass-Stegall and keeping the fucking banks from gambling with my savings was a pretty fucking good idea.  I think the word you are looking for is subsidized by the government.  Take away the subsidy and the costs go down.

buzzsaw99's picture

just another excuse for MOAR

walküre's picture

Bullshit. The Dollar is not rising. In a world where fewer and fewer trades are being settled in USD, there is no demand to buy and hedge in USD.

The world is shedding USD. For starters, the USD denominated commodity paper is being shed which is causing the selloff across the board. The Russian doesn't care to get less USD for his oil because he's settling in Yuan. The Russian stopped shopping for anything "Made in America" long ago. In fact, the world is shopping less and less "Made in America" for two reasons. There's less to buy that's truly made here and the world is shopping in Europe or China.

As encouraging as it may seem that commodities in USD terms are dropping, suggesting a strength in USD and a potential boom in consumption, this is really really bad news for Americans.

The process to decouple from USD will only accelerate from here on forth.

LawsofPhysics's picture

My thoughts exactly.  Also explains the velocity data.

bbq on whitehouse lawn's picture

If you sell less into the US then you will receive less USD in exchanged, less hedgeing and less exporting of dollar inflation, for the US. So now the US gets the extra dollar inflation. Rest of the world gets extra deflation (overcapacity). Leading to less new debt to pay old debt in the US more dollars locked up with no place to go .
Volacity of money goes negative, wealth evaporates leading to more printing without a place to spend it, deflation on the ground with massive dollar reserves growing from no one to lend to at a rate that would pay old debt. Implosion as dollars are avoided as a search for cheaper funding become nessasary.

So who will be lending into this impossable lending invironment?
The black hole of old dollar debt opens its maw and swallows the world. You cant rollover the old debt because its just to expensive to do so.

walküre's picture

not sure if we are in agreement or not

the rest of the world is in deflation already

USD chickens are coming now home to roost

cheaper USD denominated commodity paper and stronger USD denominated equities are a sign of that

Dollars have nowhere to go, nobody wants them outside US.

debt rollovers are not an issue when debt is near zero and even negative in Europe

NAP's picture

How do the BOJ's recent actions fit into the carry trade flows?

richiebaby's picture

If the dollar is so strong, why does it cost $2.49 for a bottle of Two Buck Chuck?

OW My Balls's picture

Cause some jew in the pipeline wants his .49 scheckels one way or another without lifting a finger.

Paveway IV's picture

It's because the price of fruit bats has skyrocketed. Since they're harvested and pressed with the grapes (costs too much to pick them out), the vinters have to recover the lost profit somehow. 

Don't worry - as soon as California fruit bats become infected and are identified as natural reserviors for ebola, Franzia will return to unloading Charles Shaw for $1.99 again at Trader Joe's. Personally, I would stock up on the $2.49 pre-ebola vintages. Prices will skyrocket for them - you'll be able to make a fortune selling them for crazy prices like $3.00 a bottle on Craig's list. I heard Soros was one of the big players throwing money into pre-ebola Chuck.

Bell's 2 hearted's picture

"The Dollar is not rising. In a world where fewer and fewer trades are being settled in USD, there is no demand to buy and hedge in USD."


haha ... are you in for a surprise


Deflation about to hit ... and that is because USD is losing steam?


yeah, uh huh

Tjeff1's picture

USD/RUB going to hit $50 soon

Madcow's picture

USA is the best looking hooker in the leper colony

walküre's picture

That used to be commonly known but is no longer true. Time for that old hooker to give it up and leave the pit to the younger ones.

Just because Wall Street used to be the King of forgeries and fraud doesn't mean the rest of the world keeps buying and believing it.

Lack of respect for Obama this week in China was a tell tale.

Madcow's picture

USA is the best looking hooker in the leper colony

disabledvet's picture

Simply false to say everyone did the same thing in response to Lehman. There was no "cigar filled room" where all the problems were solved but a full fledged panic. Not the first, won't be the last. They all end in the same way: default.

Ewtman's picture

A lot of good arguments in this article supported by EWT. But first, there will be a correction to undo the downside...







delivered's picture

I would tend to agree with points 2 through 4, but not 1 so much. The trend is definitely moving away from the USD long-term to settle trades so while over the short-term, parties may be "parking" money in the USD I see this as only a temporary event. Basically, these parties (by that I mean the wealthy) really have no idea what to expect moving forward given how FUBAR the world's economic outlook really is as a resul of unprecidented and historical (good or bad) actions undertaken by the world's largest CBs. If you asked the world's leading economist 10 years ago about the actions being undertaken by CBs today (ZIRP/QE in US, fully debt monetization in Japan, NIRP in Europe, etc.) they most likely would have responded with either a.) you're crazy as these policies are insane or b.) the world's economies are in horrible shape (or maybe c.), the world's superwealthy have taken control of the CBs to transfer as much wealth as possible). 

In any case, it is what it is, so basically what this comes down to is owning the best (or worst depending on your perspective) looking horse in the glue factory. There's just nowhere else to park large amounts of money as the alternatives to the USD are very poor if not outright terrible. The Yen's problems are well known with no solution available. The Euro is based on a fragile geopolitical environment with half the countries in a recession, economies starting to deflate, (or really, a depression) and the natives growing more and more restless (e.g., recent independence votes). No emerging market can even come close to offering the stability/liquidity of USDs (as noted in this article). As for alternatives including productive land and more specifically, PMs, even the smallest of flights out of the USD into this relatively small market would create all types of potential problems and instability. 

Just nowhere to turn until everyone decides to turn. It was noted on ZH a while back about the risks in the credit markets if parties start exiting in mass from bond funds (and the exit fees and/or other restrictions the Fed may implement). The same risks are present with the USD as if and when everyone begins to exit the same side of the trade, they will surely flip the boat. I doubt this will happen this year or next or in 2016 but the path has been set as bit by bit, little by little, and day by day, the world's dependence on the USD decreases. Just like Andy Dufrane stated in the Shawshank Redemption about geology "just the study of time and pressure". Same holds for the eventual fate of the USD as the world clearly understands the need for a competing currency but also suffers from the main problem a junky has. It is very painful to kick the habit and go cold turkey, but in the long-term, this is the best path to take (albeit the most painful over the short-term).

Wild Theories's picture

kudos for working Dufrane's reference to geology into it.

I've watched Shawshank Redemption a few times and barely remembered the exact line.

Jack Sheet's picture

Rob Kirby quote : like a supernova, the dollar shines its brightest just before collapsing to a black hole.

Hamm Jamm's picture


the global financial system is perfectly able to destabilize its self ... !!   no need for help from the states

malek's picture

A rising US Dollar could destabilize the the global financial system, just as a falling US Dollar could or any other significant change for that matter!

orangegeek's picture

the rising USD won't destabilize world markets, the rising USD will collapse them


let's be clear about this

walküre's picture

..or not. The world will keep turning and money interests will get settled in different ways. The superior role of the USD is exaggerated.

LawsofPhysics's picture

only as long as the FRN is relevant.  Let's be clear, the dollar has actually been dead for quite some time.

limacon's picture

This is a "Tragedy of the Commons" type problem .

The commons is the global trading community . This includes currencies .

Without Ostrum Principles , the system collapses into a desperate hunt for relative advantages , tariff wars , etc