One of the most common questions that foreign exchange traders ask is what matters more to the dollar - deleveraging or quantitative easing? Like many central banks around the world, the Federal Reserve is actively engaged in stimulating their economy. As recently as last week, Federal Reserve Chairman Ben Bernanke made it clear that the door is wide open for QE3. The prospect of more asset purchases should be negative for the dollar as the goal of the Fed is to reduce yields and, by consequence, the attractiveness of holding the greenback. Yet the dollar has appreciated since the Fed meeting, which tells us that the threat of QE3 has not stopped investors from buying dollars.
The strength of the dollar has nothing to do with the outlook for the U.S. economy although currencies are relative value plays and the risk of holding dollars is certainly less than the risk of holding euros given the eurozone's sovereign debt crisis. However investors continue to buy the greenback for one reason only, and that is deleveraging. To deleverage means to reduce risk, and with the high level of uncertainty in the eurozone, investors around the world are cutting back on any risky positions. In other words, even if the U.S. economy is worsening and the Federal Reserve is implementing measures that make the dollar less attractive, if the level of fear in the market remains high, the dollar can still rise.
One common measure of fear is the VIX index and the following chart shows the strong correlation between the VIX (white line) and the Dollar Index (orange line). When the VIX rises, the dollar appreciates and vice versa, which tells us that fear is driving investors into the arms of the greenback.
This relationship shouldn't be a major surprise to FX traders who are familiar with the dollar's safe haven status. Although the U.S. was stripped of its AAA rating by Standard & Poor's last August, Treasuries are still considered one of the safest investments in the world due to the market's deep liquidity. There are other AAA nations, but with U.S. yields setting records against the bonds of those other countries, it is clear that investors prefer U.S. assets. Not only is the U.S. bond market the largest in the world but other AAA nations are very sensitive to what is happening outside of their borders. For example, the U.K. is extremely vulnerable to Europe's sovereign debt crisis while Australia is sensitive to Chinese growth. The U.S. dollar is also a reserve currency and U.S. markets are seen as the best shelter against the turbulence in the markets.
Will U.S. Monetary Policy Ever Drive the Dollar Again?
As some point this dynamic will change and U.S. monetary policy could once again drive the outlook for the dollar. The natural course of this happening would be when the economic cycle turns and the global economy begins to grow. In this environment, the race to raise interest rates will be the only thing that matters and the performance of the U.S. economy will determine how the dollar trades once again. However this dynamic could also change if Germany suddenly agrees to share the burden of Eurozone debt, which would pave the way for an end to Europe's debt crisis. In this environment, deleveraging will no longer matter because investors would be looking to assume risk now that one of the greatest uncertainties has been lifted. In this environment the relative health of the U.S. economy and the Federal Reserve's stance on monetary policy will determine in how the dollar trades.
Now the chance of sudden U-turn by the Germans is slim and in all likelihood, the eurozone's debt crisis will continue to haunt the financial markets for some time. As a result, we expect more deleveraging, which should translate into additional strength for the U.S. dollar. The dominant driver of the dollar will change eventually but not anytime soon.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.