07 March 2025
George Soros, influenced by his tutor, Karl Popper (1957) developed the concept of reflexivity. In contrast to general equilibrium theory, reflexivity asserts that prices impact fundamentals by influencing expectations and perceptions of risk in a self-reinforcing pro-cyclical feedback loop. As we noted earlier this week, since 2008, the US and global economy has been supported by a positive feedback loop of low rates, forward guidance, QE, and large fiscal easing since 2020. To address the problem, the Trump Administration requires the reverse feedback loop. That might lead to the bust phase of the boom bust cycle. If fiscal tightening is large enough the cycle might end in recession. Our sense is that the Treasury Secretary Scott Bessent (who worked for Soros) appreciates that this is necessary for debt and longer-term macro sustainability.
A key reason why business cycles tend to be non-linear is because of the procyclical self-reinforcing feedback loop. That contributes to the boom-bust nature of the cycle due to the support of liquidity and build up in leverage during the boom phase. As we have often noted, the US dollar plays a central role in this process as the global reserve currency. More debt is issued in US dollars than any other currency. The dollar remains dominant in central bank reserves capital flows and trade. It is important to remember that currencies are always a relative trade.
What is interesting at the current juncture is that the real trade-weighted USD is just below the Plaza Accord level (chart 1). From 1980 to 1985, the US dollar appreciated by 50% against the Japanese Yen, Deutsch Mark, French Franc, and British Pound. Pressure from a broad alliance of domestic industry bodies and companies motivated the Regan Administration to commence negotiations that led to the Plaza Accord.
Chart 1
On 22 September 1985, the finance ministers and central bank governors of the United States, France, Germany, Japan and Great Britain met at the Plaza Hotel in New York City and came to an agreement on the announcement that "some further orderly appreciation of the non-dollar currencies is desirable" and they "stand ready to cooperate more closely to encourage this when to do so would be helpful". The following Monday, when the meeting was made public, the dollar fell 4 percent in comparison to the other currencies.
In the current episode, it is possible that the Trump Administration might seek a “Mar-a-Lago” Accord. Given the overvaluation of the dollar on a real trade-weighted effective basis our sense is that the Trump Administration would desire a lower USD while maintaining primacy in reserves and international transactions. Of course, weakening the USD while reducing the current account deficit and maintaining investment demand for dollars is not straightforward.
It is also possible that cyclical and structural dollar strength (the real trade-weighted overvaluation) contributes to a reflexive depreciation from the reverse feedback loop. The cyclical strength in the US dollar since September 2024 has already contributed to a deterioration in the Citi Economic Surprise index (chart 2). That is likely to be reinforced by the Administration’s desire to reduce the fiscal impulse.
Chart 2
Stated differently, the reverse feedback loop might already be underway and help achieve the Administration’s desire to weaken the US dollar. The implication for emerging markets and Asia is complex as growth and final demand for America’s trading partners also matters. The optimal point of the dollar smile is moderate (modestly above trend growth) for the rest of the world. If growth is too weak, the dollar could also appreciate for the “wrong reasons” (de-leveraging and risk aversion). Clearly the tariffs also add complexity.
In conclusion, phases of dollar strength often led to episodes of volatility because liquidity, volatility and leverage are intimately linked. The context is that the equity and credit risk premiums are modest, and the cost of protection (volatility) is modest for the potential risk. In Asia and EM, the drawdown from the reflexive impact of the dollar, rates and liquidity has already been significant. That is also an opportunity if there is an unwind of dollar strength and crowded positions.
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