Storm Clouds And The Dollar

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Includes: UDN, USDU, UUP
by: QuandaryFX

Summary

The Fed took actions in the financial crisis which made this decline inevitable.

As the Fed continues to increase rates, the dollar will fall.

The dollar is on the decline.

Perhaps no two words more accurately describe the factors impacting trading in the United States dollar than "Federal Reserve." That's right folks, the Federal Reserve has been pursuing economic policies which have whipsawed the dollar around over the past several years and have traumatic impacts for further weakness in the currency.

Let's start with the financial crisis of 2008. During the meltdown of 2008, the Federal Reserve was forced to act in any capacity possible to stave off catastrophe. With hundreds of billions of bad debts and derivatives on top of derivatives, the economic ball of string began to unravel. One of the first actions the Fed took was to slash the discount rate over several months to essentially zero. This action had several impacts for the overall economy and the strength of the dollar.

When the Federal Reserve lowers rates, there is a reverberation that is felt throughout nearly every level of the economic system. The reason is because nearly every single interest rate is in some way tied to the discount rate. As the discount rate falls, interest rates across the entire economy begin to fall as well. When interest rates fall, firms are able to pursue more projects since the difference between rates of return on investments and borrowing rates widens. When this differential widens, firms hire more employees to take on more projects to increase profits. At least, that's how it works most of the time. Following 2008, the Fed was forced to engage in several bouts of quantitative easing, which provided further stimulus to the system. Quantitative easing is essentially printing money to buy some form of debt security to drive down interest rates and stimulate the economy by widening the difference between borrowing costs and project returns. These two factors of lower rates and unconventional quantitative easing did much to solve the economic situation in the United States. This says nothing of the strength of the dollar, however.

The strength of a currency is based on more than just the economic activities of the regions which use the currency as fiat. Using traditional fundamental analysis, the dollar "should have" fallen when rates fell and the Fed greatly increased the supply of dollars by turning on the printing press. However, the dollar actually rallied nearly 15% during the crisis due to global investors flocking to U.S. Treasuries for security of capital. This said, we should always keep an eye out for global catastrophes which can skew any traditional fundamental analysis.

We currently have a unique situation unfolding at the Federal Reserve. For the first time in 7 years, the Federal Reserve increased rates in December. This is highly significant for holders of the dollar. When the Fed increases interest rates, the differential between returns and borrowing costs is squeezed. When this relationship is squeezed, firms are forced to pursue fewer projects, and employment and investment declines. When investment and employment declines, the currency declines since there is less demand for dollars due to fewer dollar-based business activities. Don't just trust me on this - over the last 42 years, the dollar has declined every single time the Federal Reserve has increased interest rates after a long period of holding rates stable at low levels.

Do you see the chart below? What do you notice about the strength of the dollar?

Click to enlarge

That's right folks - I don't know any other way of showing what's happening right now in the markets rather than a simple chart of price. The dollar is falling and we have currently seen the largest slowdown in price in 8 years. Already we are off 7% from the peaks established in 2015. In currency terms, that's a huge move. Unfortunately, statistics suggest there is much more downside in sight. Are you short the dollar yet?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I will trade this opportunity in the spot foreign exchange markets in short-term movements