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Fed rate hikes pose a threat of ‘breaking’ currency markets

A man exchanges US dollar bills at the exchange office.

Muhammed Semih Ugurlu | Anadolu Agency | Getty Images

With the dollar hitting a 20-year high against many major foreign currencies, the historic specter of currency market crises is looming.

Though now largely forgotten by all but those of us who reported on the event, a rising US dollar in 1985, now entering the backtracking machine, forced the then industrialized G-5 nations to intervene in the foreign exchange market and significantly weaken the dollar. to weaken.

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At a meeting in Manhattan in September, the G-5 announced the “Plaza Accord” (made at New York’s iconic Plaza Hotel) and took coordinated steps to weaken the dollar by selling dollars in the open market, while the U.S. cut interest rates to reverse the dollar. rapid rise.

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The goal was multiple: to relieve a then rigid foreign exchange trading system, in which many global currencies were pegged to the dollar, to make American goods cheaper in overseas markets amid mounting US trade deficits and to further coordinate global interest. tariff policy to synchronize economic cycles in the world.

Likewise, a rising dollar in late 1994, 1997 and 1998 caused a lot of turmoil, not only in the currency markets, but also in the global economy.

In short, while it was a much more complicated event on the Mexican side of the border, when the Fed tightened policies to cool the U.S. economy in 1994, the Mexican peso collapsed against the lower rate against the dollar. forcing Mexico to give up the pairing. , causing the peso to fall into freefall that year.

Once the peg was broken, Mexico faced huge inflationary risks as the peso plummeted against the dollar. The US actually loaned Mexico $50 billion in cash to straighten out its economic ship as inflation rose to 52% south of the border.

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It was one of the factors that forced the Federal Reserve to stop raising interest rates in what was then the worst year for US bond markets in decades.

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Again, in 1997, the Asian currency crisis and, in 1998, the Russian debt crisis (and the concomitant collapse of the Long-Term Capital Management hedge fund) forced the Fed to either delay rate hikes or cut them in ’98 in the aftermath of the systemic financial risks caused by the latest event.

In both cases, the world’s currencies were in turmoil, markets melted and the Fed was forced to either avoid planned rate hikes or cut them abruptly, to mitigate the increasing risk of overseas economic contagion that the US economy is facing. could have toppled when the emerging markets collapsed .

We may well be approaching another similar pain point today, with the Fed’s aggressive rate hikes driving further tensions in currency markets, which in turn could lead to heightened global market and economic risks alike.

Today, the British pound is at its lowest level against the dollar since 1985. The euro is selling for less than $1 in foreign exchange markets, while the Japanese yen’s weakness is at its lowest point against the dollar in 24 years. , the Bank of Japan to intervene to support its currency for the first time since 1998.

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

While fighting inflation domestically, by raising interest rates and tightening credit conditions at the fastest pace in decades, the Fed is exporting inflation to other countries and making American goods more expensive in overseas export markets.

Furthermore, a stronger dollar reduces the repatriated profits of US multinationals, putting corporate profits at even greater risk in an already weakening US and global economy.

There are risks and benefits associated with any policy effort, coupled with acceptable and unacceptable trade-offs.

We now reach the unacceptable point.

Witness the accelerated rise in global interest rates, the extremely rapid appreciation of the dollar and the parallel decline in global equities.

I’ve long maintained that the Fed will raise interest rates until something breaks. You hear the sound of breaking markets today.

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