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By Ryan Puplava

Last week I took a look at two major topics that affect the value of the US dollar index: the trade balance and the safety/risk-on trade. This week I'd like to conclude the discussion with some of the other major topics that affect how the dollar index trades. By looking at these factors, I hope to show that there are a plethora of factors that affect how the dollar index trades and that it is no simple matter. In some cases we can see that some long-existing trading patterns in the U.S. dollar are reversing while some still persist.

Chasing Returns

Sometimes the grass is greener on the other side. That's the perception one may have had of the financial markets in developed economies last year. Index performance for equities was primarily found in developed economies like Japan, United States and Germany. Performance was severely lacking in emerging economies. In fact, this trend has been taking place for more than three years for some. Here is a performance chart from some of the major indexes across the developed and emerging economies of the world. Note the steady decline of China, Brazil and Canada's equities compared to the surging performance in the markets of developed economies over the past two years.

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With the performance found in developed economies, money will shift to those markets as investors chase performance. The Treasury International Capital data that gets released from the Department of the Treasury every month shows a positive trend in net purchases of U.S. assets since June of last year. The latest report shows that foreign residents increased their holdings of long-term U.S. securities in October by $54.7 billion while the outflow of U.S. investment into foreign securities was only $19.2 billion - a positive net inflow of $35.4 billion. If this trend continues, it creates additional demand for the U.S. dollar. You can view the Treasury's last report here.

The Fed, Interest Rates and Differentials

Investors not only seek out the best returns in equities globally, but also with interest rates on fixed income. Investors will invest in the fixed income markets of those countries with the most attractive interest rates. Stable currencies and political environments are preferable, but if the interest spread is sizable, it may attract some speculation. As the fixed income markets look attractive in one country over another, due to central bank policy or economic conditions, investors will borrow in low rate markets and purchase fixed income at higher rates in other countries - what we call the interest differential. Transactions in different countries will require currencies to be exchanged. This creates the push and pull on the currency of supply and demand.

Right now, the Federal Reserve Bank is keeping short-term interest rates near 0-25 basis points and they plan to keep it that way for some time. That should allow investors to borrow in U.S. dollars near 0% and invest in short-term paper or long-term paper in another country at better rates of interest. This is a key component of the dollar carry trade. It does, however, introduce currency risk that the exchange rate becomes unfavorable in the future. As such, forward contracts may be used to cover the exchange rate risk.

I expect short-term funds will continue to be borrowed from the U.S. and invested in more attractive fixed income outside of the country, adding to the supply of our currency. However, long-term interest rates have been moving up as bond investors began to anticipate a Fed taper last summer in addition to the anticipation of improving economic conditions. This may tip the balance more in favor of the U.S. dollar if other developed economies remain accommodative in their interest rate policies like in Europe and Japan.


Source: global-rates.com, January 2, 2014

Money Supply

One of the many factors that affect the perceptions influencing traders in the foreign exchange market is economic conditions. I've already discussed the trade balance figures and money flows in and out of the country, but GDP, money supply, employment and inflation figures are economic factors that affect perceptions. The big one over the last several years has been money supply due to the quantitative easing programs of central banks in the U.S., U.K. and Japan. Note in the chart below that the money supply has been increasing every year. Not once did the year over year change in M2 drop below 0%. That means, from a traditional definition of deflation as a decrease in the money supply, not once did the U.S. satisfy the traditional definition of deflation. We can see, however, the huge changes in money supply during times of financial crisis.

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Source: Bloomberg

During the late 90s, Alan Greenspan goosed the money supply in preparation for the dreaded date when computers would no longer work and modern society was to end - called Y2K. Thereafter, we were still in a recession and in a state of war with the War on Terror. The Fed continued to goose the money supply. Despite the deceleration in money supply growth, as you can see in the chart above, note below that the money supply continued to grow. As such, investors' perception began to change on the U.S. dollar, on things and on China which was the massive user of things. Jim Puplava's prescient article in June of 2002 talked about the risks to the U.S. dollar here, arguing that the money supply wasn't likely to quit growing. He was right.

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Source: Bloomberg

Feeling Out the Dollar

As many veteran investors know, the market isn't just made up of earnings, profits and dividends but also people who buy and sell based off of gut instincts, momentum and emotions (think greed and fear). Bearish and bullish views (what we call sentiment in technical analysis) can be charted based on statistical results from polls, surveys and other ratios such as purchases and sales to identify trends and a general consensus view. One sentiment indicator I like to use on the dollar is from the commitment of traders report showing non-institutional investor's net position versus total open interest. When that ratio gets too low, usually we can expect a rally in the dollar. This is more of a short to intermediate-term indicator to gauge when sentiment is too negative on the dollar. Note in the chart below that we're nearing an area where speculators and retail investors are too bearish on the dollar, and usually this is where we begin to find reversals. It looks like the dollar is beginning to stabilize and find support here.

Dollar Sentiment Is Bearish

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Conclusion

If I could have hammered any point alone in these last two articles, it's that market psychology and currency trader perceptions are influenced by a wide variety of factors. If someone tells you they're bullish or bearish on the dollar, now you know the different factors that help contribute to perceptions and you can begin asking intelligent questions about the currency. How do you feel about the dollar carry trade? If you suggest we're entering a financial crisis somewhere abroad, will not the dollar continue to be a safe haven currency? How does the narrowing trade balance affect their view? What does the dollar chart and sentiment tell you? Is it time to be contrarian or time to ride the trend? Has the trend changed?

It's my belief that the dollar is bound to be stable with a bias higher in the future due to positive economic change in the U.S. including a narrowing trade deficit, increased money flows into the U.S. and stable political conditions. My bullishness is only tempered by the continued carry trade in the dollar as short-term interest rates are kept down by the Federal Reserve Bank. In future years, if that is lifted while other central banks remain accommodative, I expect that to be the final knockout for that headwind. Finally, the other perception that hurts the U.S. dollar is the perception that financial conditions in the world market appear sanguine for the moment allowing risk appetites to elevate. At the sign of any financial crisis, currencies traders will flock to the U.S. dollar - so where's a doomsday prophet when a dollar-bull needs one?

(Technical Thoughts)

The dollar's close today at 80.86 on the dollar index confirmed a short-term double bottom - a bullish sign in the short-term, especially as it appears the dollar is trading near support within a trading zone. Despite the bullish short-term signal, the dollar index has yet to trade back above its more meaningful long-term moving average near 81.57 (200-day). If it is able to do so, the intermediate-term trend will have to be upgraded.

Source: Making Friends With The U.S. Dollar (Continued)