The surging dollar is a signal that a colossal financial event is just around the corner


RTR2NDD9 1REUTERS/Carlos Gutierrez

The dollar is set for its strongest quarterly strengthening since 1992, according to Bank of America, a good sign that a rate hike is around the corner.

When markets expect that US interest rates will be hiked, it typically strengthens the dollar. That's because people rush to change other currencies into dollars — they can make more money in dollar-denominated investments. The higher demand for the US currency drives its value up.

In the past, significant dollar gains against other currencies have pretty much happened only during periods of extreme financial or geopolitical distress.

The last four large dollar shocks in the past 45 years have been symptoms of huge financial events: the collapse of Lehman, Britain's panicky ejection from the European Exchange Rate Mechanism (ERM) in 1992, the first Gulf War, and Paul Volcker's shock rate hikes in the early 1980s.

Today's surge is already considerably larger than the one that surrounded Lehman's collapse, although the economic conditions are very different.

Here's how it looks in historical context:

dollar shockBank of America Merrill Lynch

Here's a snippet from BAML's researchers:

In our view, another concern is that the move in the US dollar reflects a dislocation within the financial system. Capital flight to the US is a symptom of systemic risk in financial markets. Certainly dollar shocks in the past have been associated with major market events as shown in detail on Chart 8 (1981 Volker shock, 1992 ERM crisis, Lehman in 2008 and so on).

And yet despite the strength of the dollar move, apart from a few CDS events in EM, there is little sign from the components of our Global Financial Stress Index that systemic risks are surging. Most of the components are less stressed than normal.

Once again, the missing ingredient is a “rates shock”. 

The conditions in global markets right now are a historical anomaly. Rates around the world have been cut 558 times since the collapse of Lehman, according to BAML. So even a small, steady series of interest rate hikes by the US Federal Reserve is a colossal change in the global financial system — one that's sending the dollar through the roof.

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Brophy Friday 13 March 2015 - 6:17 pm | | Brophy Blog

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