A strong US dollar, a tumbling yuan – so why aren't markets collapsing?

On the face of it, things look very similar now to the way they did in January. Then, everyone feared a deflationary collapse. Now, markets are roaring ahead. What’s different?


The US dollar is the closest thing to a global currency that we have

The US dollar is surging.

The Chinese yuan is sliding.

The US Federal Reserve looks set to raise interest rates next month.

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When this happened at the start of the year, equity markets tumbled and everyone thought we were on the verge of deflationary collapse and a return to 2008.

Yet now markets are roaring ahead, in anticipation of the Great Trumpian Epoch.

What gives?

Spot the difference: January 2016 vs November 2016

In December, the Federal Reserve had raised interest rates in the US by a quarter of a percentage point. It was enough to make the market throw a hissy fit.

China's stockmarket started the year by collapsing. Oil prices were tumbling too. More importantly, the US dollar was surging, and China's yuan was on the way down.

To many, it looked as though we were heading for a full-blown bear market. In fact, this morning, I had a quick look back to something I wrote in January, and pretty much every major global market except the US suffered a correction of at least 20% from their 2015 highs.

The big concern was the US dollar. The dollar is the closest thing to a global currency that we have. Everyone needs it. So the "price" of the dollar really matters. As we've pointed out on numerous occasions, a stronger US dollar tightens monetary policy around the globe.

With the Fed planning to raise rates further, the dollar seemed like a one-way bet. But everyone feared that a stronger dollar would lead to emerging markets collapsing, to China blowing up or devaluing drastically, and to big commodities producers going bust all over the shop, with a knock-on effect on the banking sector rumblings of 2008 all over again.

Of course, as it turned out, concerns about another collapse were overblown. The Fed took fright, and talked its way out of doing any more interest rate rises. Meanwhile, the world's finance ministers caught up with each other at a G20 meeting in Shanghai. We're not privy to the exact content of the discussions, but the market largely decided that a "Shanghai accord" had been agreed whereby the dollar would stop rising, so that the yuan could stop falling.

The dollar started to retreat from its highs, and all was well with the world once again. Gold shot up as the dollar dropped, but so did global markets as the yuan stabilised. We were back to a "Goldilocks" world the economy was still too weak to allow interest rates to rise, but it wasn't so bad that we were going to collapse into a deflationary black hole and be crushed by a soaring US dollar.

Now, take a little look at what's going on today.

The US dollar is surging. The yuan is tumbling. Emerging-market dollar debt looks wobbly again. Gold is on the slide. So far it looks like January revisited.

And yet stockmarkets are largely higher, and there's no obvious sign of panic. In fact, market sentiment is almost the complete opposite of what we saw at the start of the year. There's no hint of morbid despair or fear of a repeat of 2008. Indeed, if anything, there's a touch of irrational exuberance going on.

So what's the difference?

The big difference between January and today

This, of course, was mistaken. Central bankers are never out of ammo, because there is always more money to print and there are always more ways to make it available.

In fact, here's what I wrote at the time: "I am worried in the longer run that we will face a crisis, and it'll hurt more than 2008. But I think it'll be an inflationary, not a deflationary crisis. And the more I hear panic about deflation, the more I think that everyone is worrying about the wrong thing."

Over the course of this year, it's become ever clearer that central banks don't want the responsibility that's been thrust on them. They've been preparing the ground for interest rate rises, and for handing over to governments.

The Bank of Japan has sworn to lend the Japanese government interest-free money for as long as it takes to get Japanese inflation above 2% for a prolonged period of time. The Bank of England has been trying to kick small landlords out of the housing market because it knows they're going to get slaughtered when rate rises finally come.

Now Donald Trump has been elected US president. Markets believe he will be a big spender. And I think they believe it even more with him than with Hillary Clinton, because they suspect that he is mildly unhinged (it helps that he doesn't face a hostile Congress holding him back, as the Democrats have for the past few years).

In short, what we're seeing is a market that finally believes inflation is genuinely possible, and that we're extremely far away from being "out of ammo".

So the real difference between January and today is that the baton is being passed from central banks to the government. And unlike central bankers, you can rely on governments when they've been given a mandate to do so to spend as irresponsibly as they possibly can.

As MoneyWeek favourite Russell Napier has reminded us on any number of occasions: "Deflation and democracy don't mix". If you want to know why voters went for Brexit and Trump, then that's probably a better answer than most.

Investors are hoping for the best of all worlds

Bank stocks are up because their interest margins will improve as the yield curve steepens (in other words, as the gap expands between the short-term rates that they borrow at and the long-term rates that they lend at).

Bonds and dividend stocks are down because investors now believe that yields in the near future will be more attractive than the yields on offer today. Growth stocks (mainly the tech sector) are sliding too, because you don't need to pay a big premium for high growth rates if the economy is going to be booming again. (Not to mention that if there's one stockmarket sector that enjoys a whiff of "elitism", it's the tech sector).

Meanwhile, gold is down because investors believe that we will get real growth, rather than just inflation.

This is where I think investors could be sadly mistaken. Will Trump drive a boom? Or will he just fuel a debt-driven sugar rush that eventually demolishes bonds and rattles confidence in the global reserve currency?

I don't know yet. But I'm hanging on to gold rather than bet it all on the former option.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.