FX International Payments
By Frances Coppola
Many saw the Federal Reserve’s monetary policy as the key driver of the dollar’s exchange rate strength. However, strong U.S. economic growth also contributed. The U.S. outpaced other developed economies in 2018, growing at an annualized rate of 3.5 percent. But the strong dollar had consequences for U.S. businesses and markets all over the world, as rising dollar exchange rates triggered economic crises in several developing countries.
Global economic growth was strong for much of 2018. But storm clouds were gathering. The Eurozone’s strong growth of 2017 petered out,2 and China’s economy started to slow. In November, the Organization for Economic Co-operation and Development (OECD) lowered its forecast for global growth, saying that economic expansion had peaked.3 As 2018 drew to a close, the Fed downgraded its outlook for the U.S. economy.4 Stock markets plummeted, and the dollar’s exchange rate briefly fell.
As 2019 dawned, volatility returned with a vengeance. U.S. equities recovered much of their 2018 fourth quarter decline, but the global economic outlook remains highly uncertain.
The Fed raised interest rates four times in 2018, bringing the Federal Funds Rate to a range of 2.25-2.5 percent by the end of the year.5 Simultaneously, the assets the Fed was holding as a result of its post-crisis quantitative easing (QE) programs fell from nearly $4.5 trillion in January 2018 to just over $4 trillion in December.6 The Federal Open Markets Committee (FOMC) said that rate rises were justified by the strong U.S. economy, falling unemployment, and inflation “near” the Fed’s target of 2 percent.7
Simultaneously raising interest rates and shrinking the Fed’s balance sheet reduces the quantity of dollars circulating not only in the U.S. but also in the global economy. Additionally, at the beginning of 2018, the U.S. Government introduced measures to encourage U.S. corporations to repatriate dollars from overseas to the U.S. mainland. This may also have reduced dollar supply in the global economy.8 Thus, U.S. Government and Fed policy combined are making dollars scarcer for international businesses. In 2018, this translated into a rising dollar exchange rate.
Evaluating the effects of the strong dollar on U.S. business reveals that dollar scarcity could be a drag on trade. And a strong dollar can also raise credit risks. When dollars are expensive, overseas suppliers and customers can have difficulty raising finance. This can increase payment defaults and force customers to cut orders.
Some economists believe the Fed’s pace of monetary tightening is too fast.9 One reason for this is the U.S. Treasury yield curve, which plots the difference between short- and long-term Treasury yields. In theory, simultaneously raising the Federal Funds Rate and shrinking the Fed’s balance sheet should lift U.S. Treasury yields. If anything, the yield curve could steepen, as longer-term yields would rise due to the Fed reducing its purchases of longer-dated Treasuries, leading to a wider gap with short-term yields. But in 2018, the yield curve has progressively flattened as interest rates have risen. In December, the yield curve came close to inverting, which is often regarded as a leading indicator of a recession. It’s not easy to predict how this would affect the dollar exchange rate, though. Often, a flat or inverted yield curve is associated with a weaker dollar exchange rate. However, in the Great Recession of 2008, the dollar exchange rate rose despite the inverted yield curve, as investors fled to “safe havens” such as U.S. Treasuries.
Another reason economists worry that the Fed may be moving too fast is that Fed policy tends to affect monetary policy in other countries. In 2018, many countries raised interest rates and introduced other measures to calm inflation arising from increasingly expensive imports due to the strong dollar. This dampened growth in those countries, contributing to the global economic slowdown identified by the OECD.
Perhaps the most significant effect was on China. China’s currency, the yuan, does not float freely against the dollar, but is “fixed” each day by reference to the market price of the “offshore” yuan traded through Hong Kong. In 2018, the yuan’s exchange rate fell significantly versus the dollar.10 This tends to help China’s exporters and widen its trade surplus with the U.S., but it also makes dollar financing more expensive for Chinese businesses. China did not interfere directly with the yuan’s fall, but it did raise interest rates and clamp down on domestic credit, triggering an economic slowdown which spilled over to other markets such as Australia.11 As 2018 drew to a close, news broke of a slump in Chinese imports and exports,12 which rebounded to Europe in the form of a sharp slowdown in the export-led German economy.13
The Fed’s chair, Jerome Powell, has said that the Fed will continue to shrink its balance sheet in 2019. However, because of the worsening economic outlook, there could be fewer interest rate rises. Consequently, many analysts predict a weaker dollar exchange rate in 2019.14
Oil is one sector that typically responds to the dollar’s exchange rate and U.S. economic policy, more generally. Oil is priced in dollars, so when the dollar’s trade-weighted exchange rate rises, oil prices can fall. Despite the strong dollar, however, oil prices rose during much of 2018, driven by strong global demand and falling production in some oil producing countries, notably Venezuela and Angola.15 But U.S. oil production is rising rapidly;16 the U.S. became a net oil exporter in 2018.17 This helped to create a global supply glut, which put downwards pressure on prices towards the end of the year.
Looking ahead, the U.S. is aiming to achieve energy independence, and could soon become the world’s dominant oil producer. In addition to putting downwards pressure on oil prices, this may intensify moves away from pricing oil in U.S. dollars, potentially signaling the beginning of the end of the dollar’s international reign. This could mean far more volatility in the dollar’s exchange rate going forward.
In the decade since the financial crisis, global demand for dollars has been supported by strong growth in developing countries. But now, the era of exceptional monetary policy is coming to an end. Interest rates are rising, the Federal Reserve is shrinking its balance sheet, and other central banks are ending their own QEs. Tighter monetary conditions are making international trade more expensive and raising credit risks for businesses. Global growth is slowing, and storm clouds appear to be gathering over the U.S. economy. The OECD forecasts “rough seas” in 2019.18 Given all this rising uncertainty in the course of the dollar exchange rate, businesses may wish to hone their FX risk management strategies to help them avoid the rocks.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “U.S. dollar trade-weighted index (Broad),” FRED Economic Data; https://fred.stlouisfed.org/series/TWEXB
2. “Eurozone growth slumps to lowest level in four years,” The Guardian; https://www.theguardian.com/business/2018/oct/30/eurozone-growth-slumps-to-lowest-level-in-over-four-years
3. “Editorial: Growth has peaked: Challenges in engineering a soft landing,” Organization for Economic Cooperation and Development; http://www.oecd.org/economy/outlook/growth-has-peaked-challenges-in-engineering-a-soft-landing.htm
4. “Fed cuts outlook for US economic growth in 2019,” Financial Times; https://www.ft.com/content/225bf402-03b1-11e9-9d01-cd4d49afbbe3
5. “Open Market Operations,” Federal Reserve Board; https://www.federalreserve.gov/monetarypolicy/openmarket.htm
6. “Recent balance sheet trends,” Federal Reserve Board; https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
7. “FOMC Statement December 2018,” Federal Reserve; https://www.federalreserve.gov/newsevents/pressreleases/monetary20181219a.htm
8. “Repatriated profits total $465 billion after Trump tax cut – leaving $2.5 trillion overseas,” Marketwatch; https://www.marketwatch.com/story/repatriated-profits-total-nearly-500-billion-after-trump-tax-cuts-2018-09-19
9. “PIMCO’s Fels says Fed risks hiking rates too fast,” Reuters; https://uk.reuters.com/article/us-investment-summit-pimco/pimcos-fels-says-fed-risks-hiking-rates-too-fast-idUKKCN1NI28P
10. USDCNY, Bloomberg https://www.bloomberg.com/quote/USDCNY:CUR
11. “China’s credit crackdown is starting to bite and we won’t be spared,” Australian Financial Review; https://www.afr.com/news/economy/chinas-credit-crackdown-is-starting-to-bite-and-we-wont-be-spared-20170815-gxw6xl
12. “China December Trade Slumps as Trade War, Economic Slowdown Bite,” Bloomberg; https://www.bloomberg.com/news/articles/2019-01-14/china-posts-record-trade-totals-in-2018-amid-tariff-war-threat
13. “Germany’s Sharp Slowdown Fans Fears That China Woes Are Spreading,” Bloomberg; https://www.wsj.com/articles/germany-economy-slows-in-worrying-sign-for-global-growth-11547545471
14. “U.S. Dollar Exchange Rates: Analyst Reaction to Federal Reserve’s Landmark Policy Shift,” Pound Sterling Live; https://www.poundsterlinglive.com/usd/10571-u-s-dollar-exchange-rates-analyst-reactions-to-federal-reserve-s-landmark-shift-in-u-s-interest-rate-policy
15. “The rise and fall of oil prices in 2018,” Petroleum Economist; http://www.petroleum-economist.com/articles/markets/trends/2018/the-rise-and-fall-of-oil-prices-in-2018
16. “Weekly U.S. Field Production of Crude Oil,” U.S. Energy Information Administration; https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=WCRFPUS2&f=W
17. “The U.S. Just Became a Net Oil Exporter For The First Time In 75 Years,” Bloomberg; https://www.bloomberg.com/news/articles/2018-12-06/u-s-becomes-a-net-oil-exporter-for-the-first-time-in-75-years
18. “Editorial: Growth has peaked: Challenges in engineering a soft landing,” Organization for Economic Cooperation and Development; http://www.oecd.org/economy/outlook/growth-has-peaked-challenges-in-engineering-a-soft-landing.htm