Three Possible Explanations for the Dollar's Strength

Some people may be wondering why the dollar has strengthened so much lately as the Fed has been flooding the system with dollars. Here is a quick list of possible explanations:

1) Margin Calls

U.S. markets are definitely the most liquid for commodity, currency and index futures. As these sharp moves occur, traders all over the world are forced to post additional margin. The problem is that they largely don't hold USD in cash. In fact, the global foreign exchange imbalances were so bad prior to the crisis that most people refused to hold USD - even U.S. based traders. All of a sudden you get margin calls and are forced to post either USD or treasuries. This caused a stampede into dollars

2) Hedge Fund & Mutual Fund Redemptions

As the global economic boom story took hold, U.S. investors increasingly invested abroad. Calls from top investors to buy non-USD denominated assets hit the investing public and money rushed into global plays. As the story unfolded, money was repatriated and redemptions caused the sale of equities and the purchase of dollars. These dollars largely found their way to treasuries.

3) The Purchase of Treasuries

As money runs to safety seeking any yield, as small as it may be, treasuries have been bid up like stocks in the dot com bubble. People don't care how much they pay for them any more. The consequence of this is that there are fortunes of treasuries in the market right now and the USD has in effect been taken out of circulation as it is sitting with the treasury. Then when banks in Asia or Europe need dollars for regular operating purposes (to buy commodities for example), there are none left to borrow. Everyone they ask have treasuries but no actual dollars. This forces the bid up on the dollar and adds more to its strength.

Looking Forward

We are now in a U.S. dollar/Treasuries bubble, but when that will burst is anyone's guess. I expect that when the bubble bursts, money will run out of treasuries and likely out of dollars as well. However that is not certain. What is highly likely is that several years from now, people won't be willing to lend money to the treasury for next to no yield.

For fun I have to mention the extreme negative USD sentiment that existed prior to the crisis. Remember when the highest paid model in the world, Gisele Bündchen, stopped taking payment in USD? The EUR/USD was at 1.50 at the time. That should have been a great contrarian signal!

Disclosure: Long dollar vs gold, silver, GBP.

Comments

[Alan von Al...:]

Thank you. Adding you to my author Watchlist.

2008 Oct 23 08:32 AM

[hedgeman:]

DX is a real surprise at this levels. We are adding to our shorts instead of stopping it since short EURJPY and USDJPY positions are performing nicely.

2008 Oct 23 08:48 AM

[User 143167:]

As long as you see the strength in the Yen, you know the US dollar surge is only due to the carry trade unwinding. Dollar, as well as Yen, is a funding currency and the market is hunting for dollar and yen cash to rewind these borrowings.

2008 Oct 23 08:50 AM

[EUARTE:]

The real story here is not the rise of the US$ but the slow death of the phoney €. It has no backing. It has no gold or central bank backing it. Italy hates it. The German people dispise it. The French wonder what they were thinking. It's birth was not financial but a political snub to the U.S. It has proven a tragic move for Eastern Europe. Viva il Deutchmark!

2008 Oct 23 09:35 AM

[John Lounsbury:]

There is a fourth cause for the surge in the dollar: deleveraging. As the paper pryamid of debt is unwound, dollars are sucked into a black hole. The reason the hundreds of billions of equity the government has injected in the various bailouts has not put pressure on the dollar and fueled inflation is that these dollars are retiring debt and shoring up balance sheets. All these doilars are simply replacing money already spent. Until this process ends there will be deflationary pressure, spending contraction, little inflation and a stronger dollar. As long as hundreds of billions are trying to retire tens of trillions of debt, this trend will continue. This effect may be as large or larger as all the other things supporting the dollar, including the three described by Adam Katz.

2008 Oct 23 10:03 AM

[John Lounsbury:]

Adam, I see you have discussed the factors I mentioned (above) in your October 16 article:
A Tidal Wave of Credit Expansion?
on Oct 16, 2008 | about IYF,IEV,XLF

2008 Oct 23 10:07 AM

[Pipo:]

With all this money printing the dollar is going to disappear.

Check Jim Rogers latest interview on:

jimrogers-investments..../

2008 Oct 23 10:09 AM

[Adam Katz:]

jlounsbury59, thanks for pointing that out. I should definitely have had a link to my other article.

The last point that I did actually leave out is bank guarantees. What's currently driving exchange rates is large currency flows and the fact that the U.S has some of the highest bank guarantees in the world encourages people to put their money in a U.S domiciled bank in USD. The Swiss for example have very low bank guarantees.

2008 Oct 23 10:15 AM

[E W Rodier:]

The best indicator of the dollar rally was a front page picture of the falling dollar vs the pound on The Economist a couple months ago. That was when I shorted the puond. Cover a bit too early. Good article. Thanks.

2008 Oct 23 10:21 AM

[Here's a th...:]

Perhaps it's good ol' fashion warm an fuzziness

Were would you rather have your money ?

A. Communist XYZ country threatening or invading its neighbor
B Speculative Oil unwinding in global slow down and future hedge fund regulation
C Shaky collation currencies
D Deflationary prone precious metals

2008 Oct 23 11:28 AM

[User 143167:]

Any thoughts that the dollar surge is due to any strength in US economy or financial/political/ec... system is beyond any reasoning.
If that is true, you pretty much mean the currency market believes Japan has the best economy strength or strongest financial/political system in the world. US dollar DEPRECIATES against the Yen day in and day out. How absurd is that? Anyone?

2008 Oct 23 12:26 PM

[carey_jim:]

1. America is the home of world capitalism so when America gets the flu, the rest of the capitalist word gets malaria which causes their currencies sink relative to the dollar.

2. Speculators exacerbate all financial moves including this upward move of the dollar.

3. The American government thought a weaker dollar would help exports and, as usual, speculators did the government's work but drove the dollar down too far. It is rebounding.

2008 Oct 23 12:41 PM

[Adam Katz:]

The Yen is strengthening for the same reason as the dollar. Foreign investors were taking out loans in Yen and Japanese investors were almost completely invested abroad... now all that money is rushing back to Japan.

carey_jim I don't believe that speculators are causing this dramatic rise in the dollar. This is REAL money moving into dollars for systemic reasons. The majority of speculators have lost money on this dollar surge. The only contribution they may have had was covering their dollar shorts. The move came too fast for many speculators to shift from being extreme dollar bears.

2008 Oct 23 01:11 PM

[carey_jim:]

Adam: I didn't mean to say speculators were the cause of the rise of the dollar, I meant to say that the the "Malaria" suffered by world capitalism is the cause. (But the causes of the economic "flu and malaria" are very complex and possibly not completely knowable so I'm really just being cagey.)

I also believe that speculators are preferable to totalitarian government fiats but they are also riverboat gamblers and sometimes criminals. But then again, totalitarian dictators have them beat, by far, in their criminality: Genghis Khan, Stalin, Hitler, ...

Keep up the good writing and research.

2008 Oct 23 01:48 PM