The Implications of Diverging Monetary Policies
The monetary policies of major economies are diverging for the first time since 2008. The euro zone, Britain and Japan are sustaining quantitative easing, while the United States, China and other major emerging economies are on a tightening path. The divergence is creating trends in some markets, volatility and confusion in others.
The U.S. dollar is on a strong trend, as the expectation of the Fed's tightening is driving deleveraging of dollar-financed carry trades. On the other side of the strong dollar are a weak pound, euro and yen.
The decline of commodity currencies is the clearest trend. The Australian dollar, Canadian dollar and the currencies of several commodity-export-dependent emerging economies have declined sharply. The trend is likely to continue throughout the year.
Stocks will remain volatile on conflicting news regarding liquidity and growth. Fueled by asset inflation, the United States' growth rate is picking up, and dollar liquidity is receding in anticipation of higher interest rates ahead. The growth outlook for Europe and Japan remains fragile. Their quantitative easing is likely to remain intact through 2013. Most big companies are global in their sales and earnings. Hence, their stocks will fluctuate with mixed news on growth and liquidity.
A limited crisis in emerging markets is still possible. As hot money is leaving them, they are facing difficulties in adjusting to the tighter liquidity environment. The recent political disturbances in Brazil, Egypt and Turkey amplify the uncertainties.
Gold is likely to perform well in the second half of 2013. While the rising U.S. dollar keeps downward pressure on the price of gold, rising global uncertainties support its role as a safe haven. Further, gold pricing is shifting to the East from the West. The Shanghai market is likely to overshadow London or New York within five years. Hence, the price of gold will increasingly track China's monetary policy rather than that of the United States.
The Dollar's Long Shadow
A rising dollar is the most important trend in financial markets. Its importance is in the role of dollar liquidity in carry trades since 2008. Since 2008, the Fed has communicated its intentions clearly to the financial market. It decreased the risk to using the dollar to fund speculation. Based on the surge in the forex reserves of emerging economies, it appears that trillions of dollars of hot money have flowed into emerging economies. A strong dollar is triggering a reversal. The full consequences are yet to be felt.
The U.S. economy is recovering. Without fiscal consolidation, it could be growing at 4 to 5 percent now. I believe asset inflation is driving the U.S. economy. Its current net household wealth has surged 45 percent to US$ 70 trillion from the low of US $48 trillion in 2009, and significantly above the pre-crisis peak of US$ 63 trillion. The Fed's tightening is primarily to prevent a full-blown asset bubble. Its burst could bring another financial crisis.
As the global tide of hot money recedes, the chances are that the United States' asset markets will be resilient. Much of the hot money will just vanish due to deleveraging. Some money will be reallocated to the U.S. market from others. Hence, the United States' asset prices are better supported than others.
In the medium term, the U.S. dollar's outlook hinges on the continuing rise of the U.S. stock market. It is a self-fulfilling expectation. If most investors believe in the U.S. economy, the money will flow into the country's stock market. Its rise creates enough wealth effect to sustain the economy. The strong economy justifies the optimism. The money keeps coming.
In the longer term, if the fundamentals improve sufficiently, the bubble element in the economy could be digested through flattening out asset prices while letting the economy grow. Energy and agriculture are bright spots for the U.S. economy. They are not sufficient to carry the economy. The key to the U.S. dollar's future, in my view, is in improving the quality of the U.S. labor force. Without major progress there, the dollar will collapse again.
The United States' virtuous cycle depends on lack of competition for money. The main alternative is China. Since China joined the World Trade Organization, global money flow has favored it. This was a major factor triggering the weak dollar between 2002 and 2012. After 2008, the flow to China at the expense of the United States accelerated.
When international money flows to an economy and is used to enhance its competitiveness, the optimism is validated, and the money inflow will receive its appropriate reward by sharing in the growth. However, the money could be used to finance an asset bubble. It creates paper gains for the capital inflow in the short term. The optimism is validated too, which encourages more inflow. But, this is an unsustainable dynamic. When the bubble peaks, everyone realizes that the optimism is misplaced. Capital flight follows, and with it the bubble bursts.
China's economy was mismanaged after 2008. Instead of learning from the bubble disaster of the United States and embarking on structural reforms to improve competitiveness, China merely used fiscal and monetary stimulus to amplify an existing bubble, creating a feeding frenzy of getting rich overnight. As the U.S. economy improves and attracts more money, China's bubble bursts.
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