Why Are You Still Holding Dollars?

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Includes: UDN, UUP
by: QuandaryFX

Summary

The Federal Reserve is trying to push the brakes - it's too late unfortunately.

Bloomberg is trying to call a sentiment bottom in the short term... sounds like a shorting opportunity.

The economic machine is in motion - short the dollar.

If you haven't noticed it yet, the United States dollar (NYSEARCA:UUP) is in decline. After hitting a 14-year high in December, the trade-weighted currency has reached its apex. That's right - I'm calling a top. Here's why.

Before I jump into my thesis, we need to cover some recent headlines. You see the dollar has been making the financial news lately as speakers far and wide have been discussing the recent rout. Let's start with the Federal Reserve.

Recently, Yellen shed light on the dilemma she faces as chairwoman of the Federal Reserve. The Fed is actually in a bit of a bind. In December, the Federal Reserve increased interest rates for the first time in 7 years.

Do you see the recent bump? That's right, it should be hard to see - it's a pretty small change. What matters isn't necessarily the size of the change, but rather the fact that the Federal Reserve increased rates. When the Federal Reserve increases interest rates, it sets an economic ball rolling which is very difficult to stop. As Yellen noted in her recent speech, inflation is a concern, which will limit the Fed's actions going forward.

If you remember, inflation is one of the primary factors, which the Federal Reserve has been trying to stoke for several years. When the Federal Reserve decreases the discount rate, interest expense diminishes for households and firms. When the interest expense falls, firms and individuals are able to spend more capital on purchases and hiring, resulting in an increase in economic activity and inflation.

The current problem that Yellen is watching for is that inflation actually isn't rebounding as strongly as she'd like. The Fed views inflation as a proxy for economic activity so slowing inflation is typically viewed negatively. Unfortunately, we're essentially at rock-bottom rates, which give the Fed very few options for stoking inflation.

Another headline to note is that Bloomberg recently released an article attempting to call a short-term bottom in the dollar. While Bloomberg may be correct in calling a sentiment bounce, there is still much downside remaining in the dollar based on long-term economics.

With both the Federal Reserve expressing caution and Bloomberg indicating that the dollar may bounce, one could safely assume that the dollar will probably rise in the near future, right? Wrong. You see, when the Federal Reserve increased interest rates in December, it set in course a chain of events larger than any given FOMC meeting or short-term analysis. The significance of the first rate increase of the Federal Reserve is hard to overstate.

When the Federal Reserve increased interest rates, it signaled to the markets and millions of companies that the next stage of the business cycle has begun. The reason is this - when interest rates are rising, firms begin to pay much more careful attention to borrowing costs. As borrowing costs increase, firms by necessity must only pursue those projects, which deliver higher returns. When firms pursue higher returns, fewer projects are taken or more risk is assumed.

In either case, employment is hampered and the economy lags. When the economy begins to falter, foreign investors pull investment capital from the United States leading to a decrease in demand for the dollar. This decline in demand ultimately leads to weakness in the dollar. The only exception to this rule is when a global crisis leads to capital pouring into U.S. Treasuries, driving up demand for the dollar, as seen in 2008.

You see, I believe Yellen is actually seeing all of this unfold in real time. She has noted that a slowing economy is a primary reason for a cautious outlook for rate increases in the short term. Unfortunately, I believe the cycle is already in motion. Firms are now responding to the new cycle of interest rates set in motion in December. With the cycle in motion, the inevitable decline of the dollar will continue. I see seas of red for dollar holders over the coming business cycle. It's time to short the dollar (NYSEARCA:UDN).

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 trade the spot foreign exchange markets and will capitalize on this idea in the short-term