The KES is currently trading at 120.75 per US dollar, up from 99.16 on January 3rd, 2020, at the start of the pandemic. This is becoming concerning, and other economies are feeling the effects of the dollar’s strength.
The dollar index (DXY) is currently trading at 113.56, implying that the dollar is 13.56% stronger than a basket of six major currencies, with the Euro carrying a greater weight than the other five currencies. The dollar index measures the strength of the dollar relative to the currencies of the United States’ major trading partners. The Euro, Japanese Yen, Pound Sterling, Canadian dollar, Swedish krona, and Swiss franc are the currencies used in the index.
The Federal Reserve Bank of the United States (FED) began raising interest rates in March to control rising inflation after reducing its quantitative easing program to zero between 2021 and early 2022. The FED has raised rates by 75 basis points in three consecutive months, resulting in the current rate of 3.25%. The Fed has promised to raise interest rates further at its next meeting in October. As a result, the US dollar has risen dramatically against other currencies and asset classes.
The dollar milkshake theory, as coined by Brent Johnson, CEO Santiago Capital, uses the metaphor of a milkshake in a glass where the white froth represents assets such as equities. The milk, sugar, and cream represent money that is injected and siphoned out of the economy, and a straw that is representative of monetary policy used to add or remove assets in the glass.
When the FED lowers interest rates and prints money to support economic growth, it is synonymous with adding milk, sugar and cream to the glass which raises the white froth (equities, housing, and cryptocurrencies).
When inflation runs hot and the FED is mandated to raise interest rates and remove all asset purchase programs to lower inflation, it becomes synonymous with sucking liquidity out of the market through a straw. This leads to lower asset prices (the white froth goes down the glass) and emerging economies suffer a liquidity crisis as the dollar becomes too strong.
With US inflation at 8.3%, the FED is raising rates aggressively, causing a massive withdrawal of liquidity from the markets. Furthermore, US bond yields have significantly increased, resulting in a stronger flow of liquidity from lower-ranked bonds to US bonds. It makes no sense to invest in Japanese 10-year bonds at 0.25% yield when the world’s strongest economy offers the same bond at 3.82%.
As a result, investors are selling bonds from lower-ranked economies in favor of US-backed bonds. As the liquidity crisis worsens, inflation in frontier and emerging markets accelerates, and the US is left with the decision to continue quantitative tightening (QT) and crush smaller largely indebted economies or reduce QT and suffer from domestic inflation.
Economies that have an excess outlay of dollar-denominated loans are forced to buy the dollar at higher rates to repay their debts. Their interest payments are also increasing thereby increasing pressure and possibility of default. When investors realize this, they dump the respective economies’ bonds and go for safer US government bonds.
For instance, Kenya has a $2 billion dollar-denominated bond maturing in mid-2024. If the investors realize that Kenya has a possibility of defaulting, they sell them and opt for safer bonds. In addition, the central bank of Kenya would find difficulty raising new funds in the bond market when the potential for default is deemed higher.
According to the dollar milkshake theory, the United States is stuck in a cycle in which it must protect the stock market from collapsing. As a result, excessive QT leads to bearish stock markets, raising the risk of a recession or even full-fledged stagflation. To avoid this, the Fed will be forced to reverse course and print more dollars in order to restore global liquidity. This will cause another inflationary cycle, forcing the FED to tighten again, and the cycle will continue.
The overall result of this is an ever-increasing supply of dollars and weakening of frontier and emerging economies until the US dollar is no longer accepted as the global reserve currency.
If Jerome Powell, FED chair, insists on aggressive rate hikes to deal with US inflation, Kenyans should expect the Kenya shilling to continue losing to the dollar and investors hold onto USD (the relatively stable currency), invest in US bonds, at the expense on investing in Kenyan bonds and equities.
This implies higher priced imports and thus a higher cost of living. Kenyan exporters will enjoy higher returns on exports and the trend could stimulate export-based production.
Rufas Kamau
Lead Markets Analyst at FXPesa
