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Fed rate hikes threaten to ‘break’ currency markets


A man is exchanging US dollar banknotes at the exchange office.

Mohammad Semih Ugurlu | Anadolu Agency | Getty Images

As the dollar hits 20-year highs against a slew of key foreign currencies, the historic specter of currency market crises looms.

Although now largely forgotten by all but those of us who covered the event, a rising US dollar in 1985, now entering the time machine, forced the G-5 industrialized countries to intervene on the currency market and to weaken the dollar considerably.

At a meeting in Manhattan in September, the G-5 announced the “Plaza Accord” (worked out at New York’s iconic Plaza Hotel) and took coordinated action to weaken the greenback, selling dollars in the open market as the United States cut interest rates to reverse the trend of the dollar. meteoric rise.

The goal was multiple – to relieve a then rigid currency trading system, in which many world currencies were pegged to the dollar, to make American goods cheaper in foreign markets amid growing American trade deficits, and to coordinate more global interest. rate policies to synchronize global economic cycles.

Similarly, in late 1994, 1997 and 1998, the rise of the dollar caused a lot of upheaval not only in the foreign exchange markets but also in the world economy.

In short, although it was a much more complicated event on the Mexican side of the border, as the Fed tightened policy in 1994 to cool the US economy, the Mexican peso crashed against its lower peg against the dollar, forcing Mexico to drop the bond. , sending the peso into a tailspin that year.

Once the link was severed, Mexico faced massive inflationary risks, with the peso plunging against the dollar. The United States actually lent Mexico $50 billion, in cash, to right its economic ship, as inflation soared to 52% south of the border.

It was one of the triggers that forced the Federal Reserve to stop raising rates in what was then the worst year for U.S. bond markets in decades.

Again, in 1997, the Asian currency crisis and, in 1998, the Russian debt default (and associated collapse of the Long-Term Capital Management hedge fund) forced the Fed to either delay raising rates , or to reduce them in 98 as a result of the systemic financial risks caused by this last event.

In both cases, global currencies were in turmoil, markets crashed, and the Fed was forced to either prevent planned rate hikes or cut them sharply, to reduce the growing risk of economic contagion to the overseas that could have flipped the US economy as emerging markets crashed. .

We may well be approaching another similar pain point today, where the Fed’s aggressive interest rate hikes are causing further stress in currency markets, which, in turn, could lead to both increased economic and global market risk.

As of today, the pound sterling is at its lowest level against the dollar since 1985. The euro is selling less than 1 dollar on the foreign exchange markets while the weakness of the Japanese yen, at a low in 24 years against the greenback, prompted the Bank of Japan to step in to support its currency for the first time since 1998.

Emerging market currencies are under similar pressure, threatening a currency crisis that could, once again, disrupt global financial markets, already in a global downtrend, and force the Fed to change policy.

As it fights inflation at home, raising interest rates and tightening credit conditions at the fastest pace in decades, the Fed is exporting inflation to other countries and returning the products more expensive in foreign export markets.

In addition, a stronger dollar is reducing the repatriated profits of American multinationals, putting corporate profits even more at risk in an already weakened American and global economy.

In any political enterprise, there are risks and rewards, associated with acceptable and unacceptable compromises.

We are now reaching the unacceptable point.

Evidenced by the acceleration of the rise in global interest rates, the extremely rapid appreciation of the dollar and the parallel fall in global equities.

I have long maintained that the Fed would raise rates until something broke. You hear the sound of the markets breaking today.

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