I remember well the day the stock market crashed in October of 1987.

As stocks collapsed, the dollar rallied several percent. But then the capital flows out of the dollar started, and the selling pressure kept increasing more and more.

The market was betting that the Federal Reserve would dramatically lower interest rates to support the equity market, and that further fueled the dollar’s decline.

Today, the dynamics that have driven the U.S. dollar’s behavior for years are under pressure. And as you’ll see in today’s issue, this has massive implications for traders.

What Drives the Dollar’s Fortunes?

Historically, the U.S. dollar’s behavior has been driven by many different factors.

At times, the trade numbers drove the dollar’s movement. The market would move 2% or 3% within hours after the trade deficit was announced. Other times, the dollar’s fortunes were driven by the Consumer Price Index (CPI) and inflation data.

Sometimes, the driver was a mix of fiscal and monetary policy, and sometimes it was based on nominal interest rate differentials.

In short, the dominating themes change, and they can change quite abruptly. Certain strategies, like the “carry play,” are largely gone for quite some time.

Recently, the dollar has been strengthening in a “risk-off” scenario. (As regular readers know, risk-off sentiment tends to go hand in hand with times of turmoil and economic stress.)

The dollar is recognized as the ultimate source of liquidity and the ultimate safe-haven currency. This means that when the U.S. asset markets are under heavy selling pressure, the dollar tends to strengthen. In previous cycles, the opposite correlation held.

These factors aside, everything in foreign exchange is ultimately based on relative value, so it is not so simple as to look at the U.S. situation in isolation.

Interest rates, growth rates, demographics, fiscal situation, and so on all get factored into the equation. (The U.S., though, as the world’s hegemon and issuer of the global reserve currency, gets an outsized weighting in the assessment.)

Europe is a great example of how the fiscal situation can affect the currency markets.

You see, the European Central Bank (ECB) is very worried about consumer price levels in Europe. They’re starting to embrace the idea that they will be a whole lot better off if the euro is weaker. It would make their exports more competitive and perhaps help offset some of the deflationary pressures in Europe.

There are currently three trillion dollars of excess liquidity in the eurozone. Think about this for a moment. It is staggering.

If we ever wanted evidence of the limits of quantitative easing by a central bank, this is it. This excess liquidity is just sloshing around, not doing anyone any good.

Fiscal spending will at least provide some short-term support for the economy. But if the fiscal spending is not well-planned and well-thought-out, it won’t necessarily change the future trajectory of spending.

Dramatic Change in the Current Dynamics

It is this future trajectory that must change. And this is why future fiscal spending by the U.S. must be carefully targeted and carefully executed.

We must create an environment that shifts the future trajectory of spending in the economy upward. Just throwing money at losing companies is imprudent and foolish over the long run.

Investing in infrastructure that improves connectivity, productivity, and economies of scale, and that educates or retrains, will pay dividends in the future.

But what are the implications for currency traders?

If our country spends foolishly, we could reach a point at which global investors worry about the ability of the U.S. to service and repay its debt. Then the current dynamics would undergo a dramatic change.

We could see a massive flight of capital from the U.S., as investors seek a safer place to park their money. The dollar would begin a collapse that would snowball.

It would be a very exciting time to trade, but a very scary time for all global markets.

Fortunately, we are some years away from this possibly becoming a new normal, as the current levels of debt are still manageable. But as I’ll explore in my next Money Trends issue, there is a more imminent risk facing our country today. 

To be continued…

Regards,

Andy Krieger
Editor, Money Trends