US dollar weakness likely to crash global stocks

Last Friday equity markets around the world saw one of their worst days for three years, and this may be just a taste of what is to come if the US dollar bears are proved right.

Kuwait's 1% revaluation against the US dollar was insignificant in itself but a powerful warning about the sentiment of the market which has been impacted by a perceived end to interest rate tightening by the Federal Reserve. With interest rates apparently on hold, the US dollar is less attractive than other currencies such as the euro where interest rates look likely to go higher.

David Bloom, currency strategist at the world's second largest bank HSBC, says this switch is a 'regime change' and forecasts $1.40 to the euro over the next 12 months. His warning is that phase two of a US dollar decline will result is an equity sell-off and 'an increase in volatility and uncertainty across the board.'

Complacency to end

Perhaps this change of pace should not come as such a shock. Equity markets have been remarkably benign for a long period, and a return to greater levels of volatility could be expected. Moreover, global stock markets have just posted a six-year high, and cyclical peaks are not normally long lasting.

On the other hand, the weakness of the US dollar is benefiting precious metal prices which rise in nominal terms to compensate for a weakening dollar, particularly in the case of gold which is a quasi-monetary instrument. So as the US dollar declines further the upward momentum seen in the gold price is likely to continue.

However, the sharpness of an equity sell-off and US dollar decline will determine what happens to precious metals next. If major investors all dump the US dollar and US bonds and equities at the same time then a financial crisis could push even more money into gold as a safe haven asset. But if this crisis deepened then investors might have to liquidate gold positions and gold shares to shore up their balance sheets.

Historical precedent

Many past periods of crisis on Wall Street have been precipitated by major shifts in the value of the US currency, a fact not ignored by the International Monetary Fund whose officials are concerned to ensure that US dollar weakness does not cause a full blown financial crisis. IMF officials are currently in emergency talks with governments and a US dollar support package could emerge.

The intelligent investor will not be too impressed by such developments and if holding long positions in US equities or bonds could well choose to use any period of stability underpinned by IMF intervention as a point to quietly leave these markets. For waiting around for a disaster to strike would not be a bright move.