Jack Schwager’s trader-interview book The New Market Wizards,includes an interview with Stanley Druckenmiller. Druckenmiller in my view is a smart investor and is not shy to talk about his trades.
One idea in particular caught my attention. Druckenmiller tells Schwager that:
“I never had more conviction about any trade than I did about the long side of the Deutsche mark when the Berlin Wall came down. One of the reasons I was so bullish on the Deutsche mark was a radical currency theory proposed by George Soros in his book, The Alchemy of Finance. His theory was that if a huge deficit were accompanied by an expansionary fiscal policy and tight monetary policy, the country’s currency would actually rise. The dollar provided a perfect test case in the 1981-84 period. At the time, the general consensus was that the dollar would decline because of the huge budget deficit. However, because money was attracted into the country by a tight monetary policy, the dollar actually went sharply higher. When the Berlin Wall came down, it was one of those situations that I could see as clear as day. West Germany was about to run up a huge budget deficit to finance the rebuilding of East Germany. At the same time, the Bundesbank was not going to tolerate any inflation. I went headlong into the Deutsche mark. It turned out to be a terrific trade.“
Today United states is almost in a similar situation. Covid 19 and a new cold war with China has presented an opportunity to the US to Build Back better and Fed policy has been generally been supportive of the US fiscal policy although they had started tapering their QE in Nov 2021.
as Michael Lebowitz writes
“Over the last few months, the Federal Reserve has taken on a more hawkish tone. Economic activity is more robust in the U.S. than in most of the world, and its inflation rate is higher. The justification for halting QE and raising rates is palpable. The currency markets are signaling through a stronger dollar, the Fed will remove emergency accommodations quicker than most other nations.
As a result, the U.S. dollar index has appreciated 7.7% this year to date. The list below shows how much selected currencies depreciated against the dollar over the same period.
As the dollar appreciates, foreign borrowers of U.S. dollars need more U.S. dollars to pay the loan’s interest and the principal. When borrowers raise the dollars required to meet their obligations, they cause further dollar appreciation. At times, especially during a crisis, when many borrowers are forced to take such actions, a global run on the dollar occurs and pushes the dollar significantly higher, worsening problems for dollar borrowers.“
Federal Reserve today increased its hawkishness further and has indicated tightening the liquidity and will stop doing QE altogether by early 2022. Whereas its European, Japanese and Indian counterparts will still continue to expand their Balance sheets, while the US fiscal deficit is set to surge further following a new Build Back better bill.
Conclusion
This creates a lethal cocktail of rising US deficit which needs to be funded by Bond market without any helping hand from Federal reserve. This as Druckenmiller suggested above ,should be further supportive of US dollar. Emerging markets would need to sacrifice their future growth due to this change in Fed policy and raise rates more than required/ tighten domestic liquidity or face higher currency and interest rates volatility.
Very interesting observation…!! thanks for sharing the same.