A question I must frequently ask market participants these days is this: Why are you still exposed to the United States dollar. After an unprecedented rally of over 30%, it really is important to seriously considering reducing exposure to the currency. After all, how high can this thing really go? Have we forgotten the short and long-term fundamentals which have brought us to this point?
You see, the recent run-up in the dollar is off the charts. What we've seen is a perfect confluence of economic factors which drove the dollar to ballistic heights. Unfortunately, these factors have changed and those who are still long the dollar will most likely be left holding the bag.
Prior to 2008, there was a steady decline in the dollar as the fiscal and monetary policies led to a persistent weakening in the currency. The debate of the times was in regards to outsourcing with export and manufacturing jobs impacted over the years. The political and monetary forces of the day united to weaken the dollar and provide a degree of relief to industries. As the dollar weakens, foreign investors or purchasers can more easily acquire dollar-priced goods, driving up sales for manufacturing firms.
However, in 2008, the world changed. With the meltdown in the subprime markets which led to many of the major financial firms collapsing around the globe, investors fled to quality. The gold standard when it comes to financial stability is the United States Treasury. To purchase Treasuries, investors need dollars. This demand for dollars led to the fastest run-up in the currency seen in several decades. In fact, we have only recently surpassed this increase in dollar strength.
Throughout the financial crisis, the Federal Reserve has played a very active role in attempting to stabilize the debt markets. These activities have had tangible impacts on both the strength of the dollar and the volatility of the currency.
What's most noteworthy is that when the Federal Reserve has announced major policy shifts such as persistent, ongoing quantitative easing programs, the dollar has responded. In 2010-2011, the Federal Reserve acted by purchasing $600 billion in Treasury securities to force interest rates down. The goal of the move was to both stimulate the housing market and keep interest rates low for business borrowing. With low borrowing costs, firms are able to pursue more projects which both increases employment and overall economic activity. When this round of quantitative easing was announced, the dollar bottomed and began a rally which has only recently started to slow.
The rally which began in 2011 has run its course. For almost the entirety of the rally, the market has been responding to changes in quantitative easing policy. You see, when quantitative easing acts to depress the yield curve, foreign investors are attracted to U.S. markets. With lower interest rates for borrowing, foreigners are able to gain access to cheap funds to engage in business with lower borrowing costs. This borrowing drives up demand for the dollar which increases the value of the currency. Quantitative easing ended in October 2014, but the base demand for the dollar remains as long as interest rates are weak. If you've been reading the news, weak interest rates have more than likely ended.
When the Federal Reserve increased interest rates for the first time in 7 years last winter, it set off an economic chain of events. As interest rates recover, the dollar will continue weaken. The vast majority of demand for the dollar has come from interest rate and yield curve decisions over the past 8 years. These decisions have resulted in heightened demand for the dollar as foreign investors have sought either safety or access to cheap borrowing costs. Unfortunately, this era is over. It's back to business as usual. And business as usual is a weakening dollar due to progressive outsourcing, a declining labor market, and slowing GDP. The good times are over. It's time to short the dollar (NYSEARCA:UUP).
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 in the spot foreign exchange markets on a short-term basis