Is The U.S. Dollar's Fall Finally Over?

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Includes: UUP
by: Matthew Allbee

Summary

As the AMEX Dollar Index (DXY) has finally reached an area of support after months of declines, investors are asking themselves whether the decline may finally be over.

To figure this out, I look into the major factors affecting the Dollar's value.

Finally, I explain why now may be a good time to stay on the sidelines and wait for something to tip the scales.

The Dollar (NYSEARCA:UUP) has been in a slump lately. Since its high in November of 2015 just above 100, the DXY index which measures the dollar against world currencies has fallen almost 7% to 93.77. The index had been rising since 2014 as the U.S. economy performed better than most other major economies leading to increasing expectations of the Fed tightening monetary policy consistently throughout 2016.

After the first rate hike in December, though, the economy began to weaken as GDP growth began to slow. More importantly, inflation has also showed. Without inflation, the Fed will have no real incentive to raise as the "hawks," or Fed members most concerned with inflation, will be mollified.

In fact, things aren't nearly good enough that the Fed would be worried about raising interest rates if they weren't forced to start from so low. Inflation is not showing many signs of flaring up, and global headwinds are pushing down on the U.S. economy. Ironically, this is exactly why interest rates need to be higher - if things worsen the Fed won't have many tools to fight a downturn with rates already depressed.

In the currency market, what goes down usually comes back up, and the DXY index has finally reached a historical support level. Could we finally be seeing the dollar bottom after months of declines? Two things primarily move the currency market: the relative performance of an economy, and the monetary policy in the economy. To figure out where the U.S. Dollar is likely to stand in the next months, we must look into how things are likely to change.

The U.S. vs. The World

The U.S. is sensitive to international economies primarily through trade. By far the largest trade partners of the U.S. are Canada, China, and Mexico. Canada, famously dependent on its large oil reserves, has been severely hurt by the steep drop in oil. With the price of crude suddenly jumping in the past months, Canada may begin to recover, but it is still to be seen how crude will fare over the coming months.

While Canada depends on a high oil price, China has a large role in actually setting the price. Partly the reason for rising oil prices, China seems to be avoiding a hard landing, a situation in which its accelerated rate of growth falls precipitously.

Because of China's reign over crude prices, Canada is also reliant on China for economic well-being. China may very well decide how the Canadian economy develops over the next months.

Lastly, Mexico has managed to perform well despite the global headwinds affecting most other economies. While the Mexican Peso has lost 30% of its value against the U.S. Dollar, this hasn't (yet) caused inflation in the country. Whether or not inflation flares up willing be a defining variable for Mexico in the future.

Altogether, much of the world has been at the mercy of China and oil prices over the last year. If China can continue to maintain around its current rate of growth, trade with the second-largest economy and rising oil prices should significantly reduce the global headwinds that the Fed is worried about.

Inflation

Even if the worldwide economy improves, it will mean nothing if inflation doesn't pick up. Despite an epic infusion of Dollars into the U.S. economy over the last 9 years, inflation has remained stubbornly below the Fed's target annual rate of 2%. This has lead some to even put forward the idea that a low-inflation economy may be the new normal.

What is causing inflation to be so stubborn, though? According to a recent paper released by the Federal Reserve, inflation expectations themselves are helping to keep inflation down. In many economic models, inflation expectations are a big part of how society decides on how much labor to demand, how much to work, and how much to consume. So, when expectations for inflation go down, it can actually cause inflation itself to fall.

That's not likely the only reason for the current inflation environment. There are signs that companies are using the cheap money they can borrow, a result of the huge growth in money, to stock up for future times when money isn't so cheap. Instead of using the extra money to add value to the economy, they are using it to stock up on inventory - taking value out of the economy until the inventory is sold.

This "sucking up" of money, in various forms, can be shown from the change in velocity of money since the Great Recession. If money is being spent less quickly, it can offset the fact that more money is being pumped into the economy. This is shown in the Quantity Theory of Money.

You may have heard of how this plays out, called the Paradox of Thrift. By saving more, consumers and businesses can actually hurt the economy by taking money out of circulation. As long as this process continues, inflation is likely to stay below what would be expected in normal economic times.

Conclusion

Whether the Dollar will rise or fall in the future depends primarily on three things: oil, China, and inflation. While inflation is not showing signs of improving much as of now, this could change should China return to normal growth bring oil prices with it. From what I've seen, inflation projections are continuing to get worse - which we've seen can be a self-fulfilling prophecy. If China continues to improve, it seems likely that inflation projections should pick up somewhat. They will continue to face downward pressure though.

I believe the current outlook for the U.S. Dollar seems to fit well with the data. Because of this, I would not buy or sell. The Dollar could go up or down, but it will largely be affected by factors we cannot currently forecast.

Disclosure: I am/we are short EUR/USD.

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: The position is short-term and will be closed on Monday.