Will a surging US dollar cause another financial crash like in 2008?

The recent sudden 20 per cent plunge in the value of the euro and the rapid recovery of the US dollar is similar to what happened in 2008 before Lehman collapsed and global financial markets crashed, HSBC warns in its regional currency commentary published today.

‘In 2008, the Federal Reserve ignored the rising dollar demand, letting it appreciate, which eventually led to the collapse in stock and commodity markets,’ said the leading regional international bank. Much the same could be said of the behavior of the dollar in the run up to the 1987 Wall Street Crash.

Deflation and debt

As HSBC explains: ‘The appreciating dollar is increasing deflation pressures in the US and dollar linked Chinese economies. An appreciating currency increases deflationary pressures and is worrisome in an economy struggling with high debt and leverage levels.’

Lest we forget deflation increases the real burden of debt on an economy, while at the same time cutting into the income required to pay debt interest and principle. The danger is that a vicious cycle of debt deflation develops – with debt rising and income shrinking in real terms – such as happened in the 1930s.

Indeed, the whole rationale for the huge bailout packages around the world, and particularly in the US and China, has been to prevent deflation taking hold by countering this downturn with a burst of artificially induced inflation from low interest rates and higher public spending.

Not a perfect solution

The problem is clearly that this is unlikely to have worked as a perfect cure. Too much stimulus and you get consumer price inflation. Not enough and you have deflation.

Currently US prices are falling while Chinese prices are up. That suggests the Chinese have overheated their economy while the US has undershot, perhaps because borrowing capacity is greater in the former than the latter.

Now what does this mean? It looks very much as though a double dip or even thunderbolt shaped recession is going to be unavoidable after all, despite the optimism about the fragile recovery since the spring of 2009 – something ArabianMoney has long seen as unrealistic.

That puts HSBC right on the money with its causal connection between the dollar and wider financial markets. The rising dollar will drag down stocks and commodities for a myriad of obvious reasons, from lower profits for IT giants trading in Europe to downward pressure on commodities priced in dollars.

Another good reason to sell financial markets and sit on cash in US dollars.