Review Of Existing And New Sources Of USD Strength

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Includes: FXE, UDN, UDNT, USDU, UUP, UUPT
by: FX Analyst

Summary

Overview of the 12.7% rise of the USD from June 2014 to now.

Existing strength of economic and monetary divergence discussed.

New safe-haven appeal after the threat of a Greek exit provides new strength for the USD.

The USD is likely to strength further until the Greek issues are resolved.

Important dates to look out for this month.

The US dollar (USD) as reflected by the FXCM US Dollar (USDollar) has strengthened 12.7%, from a low of 10369 in June 2014 to a high of 11685 this month. Its rise has caught the attention of the media, and this is generally well known even by the non-investing public at large. In this article, I am going to compile the old and new reasons for the USD strength and provide my outlook for the USD.

Before that, let us take a look at the USDollar in the chart below. The USDollar follows the performance of the USD against a basket of the most liquid currencies in the world, such as the EURUSD, USDJPY, AUDUSD and GBPUSD. This basket covers 80% of the world spot market activity, and reflects a diverse economic and geopolitical makeup.

The USDollar chart above shows the strong rally of the USD since June 2014. Even if the pace of increase has slowed down, the USD strength is still consistent. In this article, I am going to review the strength from the existing and new drivers of USD strength.

Existing Strength

Divergence of monetary policy - This is the primary cause behind the strength of the USD. This has been mentioned before, so I am going to briefly describe this. The Fed is on the monetary tightening cycle after ending QE3 in October 2014, and it has signaled its intent to raise the Federal Funds Rate in June 2015. On the other hand, major economies such as Japan and the eurozone had committed to expand their balance sheet by 80 trillion yen and 3 trillion euros respectively, and this is a reason behind their weakness. This contrast in monetary policy is encouraging international capital to leave these countries for the USD, with the pending rise in interest rates.

Divergence of economic performance is linked to the earlier point. The US has grown by 5% in the third quarter of 2014, while Europe and Japan grew by 0.2% and -0.5% respectively. Japan is actually in recession after the implementation of a consumption tax from 5% to 8% amid falling wages pressures. Even though the euro and the yen have fallen, it was not enough for them to export their way to prosperity. This is why both countries are determined to follow US footsteps to ease their way into growth. Whether they will be successful is another matter. The market is just focusing on their shrinking or barely growing economy, and has moved their funds to a market where there is more growth prospect, and along with it, a better return on their capital.

New Strength

Safe-haven appeal - This is a relatively new strength which gained momentum at the expense of the euro. It seems that Greece wants to have its cake and eat it too. Greece wants to stay in the eurozone and enjoy the prestige and financial support from the International Monetary Fund (IMF), European Central Bank (ECB) and European Commission (EC), collectively known as the Troika. So after the country has returned to its primary surplus in its budget with the help and supervision of the Troika, it announced its intention to repudiate its debt.

This is totally unacceptable to other European countries, most notably Germany. This demand will force Greece out of the eurozone. This threat of a Greece exit (or Grexit) and the subsequent 30 billion euro debt default will throw the eurozone into financial and political chaos. This came into play after the political party Syriza rose into power by tapping on the pain of austerity suffered by the Greek people. They campaigned on debt relief, and are now trying to ratchet up their rhetoric as they attempt to force a snap election. There is a strong possibility that the party will form the new government if it happens. This has strengthened the USD and the Japanese yen. Most notably, despite Japan's own internal debt problems, the recent 10-year Japanese bond sale on January 6, 2015 saw a higher bid-to-cover ratio of 3.4 over the previous month of 3.0. This auction also saw a lower interest of 0.30%, compared to 0.47% previously.

Given the growth and debt overhang problems facing Japan, investors would prefer to put their money in the USD against possible losses. The US welcomes international capital, and it is not imposing negative deposit rates as seen in Switzerland. Switzerland would have been a strong beneficiary for the safe-haven funds, if it were not for the Swiss National Bank (SNB) opposition. The SNB would like to prevent deflation from gripping Switzerland, and hence, it set a minimum CHF1.20 to EUR1.00 exchange rate and prevented euro funds from flooding Switzerland.

Conclusion

The existing strength of the USD is still being played out. The US economy is still strengthening, and the Fed has not raised interest rates yet. Then Greece played its brinkmanship card to secure concessions from the Troika. Although we do not know if the Troika is able to resolve this successfully, the very specter of a Greek exit weighs heavily on the euro. It has been compared with the failure of Lehman Brothers, which sent the world into recession.

There are likely to be financial linkages between Greece and other nations and their banking system that will likely be revealed once Greece reneges on its debt. This will cause massive pain and cause another set of dominoes to fall. The geopolitical fallout will also have massive unexpected consequences.

Rational investors will not want any of this non-quantifiable risk, and would continue to sell their funds (mostly euros) and convert it to the USD. This is likely to pick up pace until there is a real resolution over this whole Greece mess. Hence, it is my opinion that the USD will continue to strengthen. We should look out for the upcoming Federal Open Market Committee (FOMC) meeting on January 28, 2015, the ECB meeting on January 22, 2015; the opinion of the European Court of Justice (ECJ) on the legality of the ECB monetary easing program known as Outright Monetary Transaction (OMT) employed on September 6, 2012 to stabilize the eurozone on January 14, 2015, and lastly, the FOMC minutes for the December 2014 meeting on January 7, 2015. These events are listed in order of their importance.

The importance of the 3 above-mentioned events relating to the FOMC and ECB meetings is apparent. The ECJ makes a rare appearance in financial matters, and I shall explain the implication of their ruling. If the ECJ rules against the ECB's OMT, it will hinder ECB's decision to purchase sovereign bonds this year. The euro might have a short rally, but it will be overshadowed by the concerns of a eurozone disintegration and quickly plunge the value of the euro. That said, the market expects the ECJ to side the ECB over Germany's objection and hence preserve the status quo. However, the risk of a surprise ruling remains, and it has widespread implication over the future of the eurozone, and investors should mark it on their calendar.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author is long the USD.