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In Part 1, we reviewed the deterioration of the dominant narrative of the past six years—that central banks can move markets higher and generate growth more or less at will.  In shorthand: central bank omnipotence.

Three dynamics are undermining that narrative: diminishing returns on central bank monetary policies and public relations pronouncements; a collapse in oil prices that is destabilizing a key sector of the global economy, and the strengthening U.S. dollar, which is wreaking havoc on emerging-market currencies and economies.

If central banks really had such absolute control of the financial universe, would they let these three trends undermine their policies and power? The answer is clearly “no.”

There are a number of other factors undermining the “central banks are in control” narrative, but the field of battle where central banks are most likely to lose is foreign exchange (FX), for two fundamental reasons:

1.  The FX market dwarfs the central banks. The equivalent of the entire Federal Reserve balance sheet ($4.5 trillion) trades in the FX markets every few days.  Given the size of the market, central banks cannot manipulate the FX market via proxies or direct purchases for long. The only central-bank controlled factors that influence FX are interest rates paid on government bonds and money-printing. The first supports the currency, the second weakens it.

2.  The FX market is still an open market, influenced by government bond interest rates, trade deficits and surpluses, perceptions of risk and speculative bets. This mix is much more dynamic than the two levers controlled by central banks: setting interest rates targets and creating new money to buy bonds.

Let’s trace the primary dynamics of the FX market, which is currently being destabilized by the rising U.S. dollar…