The soaring US dollar is causing mounting strains for the global financial system and ultimately threatens to set off a full-blown banking crisis in emerging markets, the world’s top’s economic watchdog has warned.

“We have all the symptoms of a dollar shortage,” said Hyun Song Shin, chief economist at the Bank for International Settlements.

The warning came as the closely-watched dollar index (DXY) appeared close to breaking through key resistance levels to a 14-year high, a move likely to trigger a stampede into the US currency as hedge funds and momentum traders join the chase.

The danger is that the powerful and immediate effects of financial tightening will “swamp” any trade benefits for the rest of the world from Donald Trump’s stimulus plans and a stronger dollar, even for countries that export heavily to the US. “It may not be very good news for anyone,” Mr Shin told a specialist forum at the London School of Economics.

The BIS estimates that dollar debt outside US jurisdiction - and therefore lacking a direct lender of last resort - has risen five-fold to $10 trillion over the past 15 years.

It has spiked to $3.3 trillion in emerging markets. This is chiefly due to the leakage of cheap dollar funding from the US while quantitative easing was in full flow. The debts will have to be rolled over in a stronger currency and at a much higher rates.  

What is less understood is that the surging dollar automatically squeezes the balance sheet of banks in Europe and Japan through the complex structure of swap contracts. “The dollar is everywhere,” said Mr Shin.

David Fuller's view

This service pointed out in 2H 2014 that the Dollar Index (DXY) (monthly historic & weekly) was breaking up out of its base formation and commencing a secular bull market recovery, fuelled by the USA’s energy independence, increasing technology lead, and its dominant, multinational corporate autonomies. 

We also pointed out that DXY had completed its initial upward leg near the 100 level in 2Q 2015, and that the subsequently loss of upside momentum confirmed the commencement of what was likely to be a lengthy medium-term consolidation before the bull market resumed. 

I have often mentioned that surreptitious intervention by the US Treasury on behalf of the Federal Reserve almost certainly occurred near DXY’s 100 level. Additional gains would have been a headwind for the global economy because other developed economies were either still in recession or lagging the US economy’s modest recovery.  Additionally, DXY strength can lower overseas earnings for US Autonomies. 

All of this remains a risk now that DXY is pressing against the 100 level once again, although countries have had more time to prepare for the eventuality of a stronger Dollar.  Intervention near 100 is unlikely be as effective today, given the build-up of support and rising lows for DXY since its trough at 92 in May.  President-elect Trump’s big spending plans and that upward dynamic last week have convinced currency traders that further Dollar strength is all but inevitable.  Countries which have not prepared for this are vulnerable and further US Treasury / Federal Reserve intervention may not occur until the DXY strength looks overextended once again.      

Here is a PDF of AE-P’s article.