The Good, Bad And The Greenback

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Includes: ERO, UDN
by: Kalyan Venkat

Summary

The dollar has been steadily weakening since January this year.

Political chaos is causing this weakness.

The dollar index is likely to move lower in the coming months.

I have to admit that the resilience of the stock market despite the constant theatrics every other day from the current U.S. administration has left me bewildered. The market was not showing any semblance of a correction before last week. I think that it is probably expecting a steep tax cut that will shore up earnings for companies, and thus shrugged off these political issues. Things have been going well for investors so far. But one market is seeing something very different, and it is one of the largest markets in the world -- the dollar market.

The dollar has been weakening at a rapid pace the last few quarters. The dollar's ascent as the reserve currency of the world is due to three characteristics it has exhibited for many years:

  1. The rule of law governance
  2. A robust and stable economic environment
  3. Reliable and predictable political leadership

Some cracks are beginning to show on the third point, and currency markets have taken notice. First, the collapse of healthcare reform clearly showed that the problem is within in the GOP and not outside, as the two GOP factions came to the fore with opposite views on the bill and nothing was done.

Tax reform will be no different, because the same forces will be in play. The only thing that has a good chance to pass is the infrastructure bill, as there is some bipartisan support. But that, too, is a long shot.

Finally, there is a looming September deadline for avoiding a government shutdown. GOP members will know that the advice they gave to the previous president -- that the increases in the debt limit should match the spending cuts -- will come back to haunt them. Markets will be keenly watching this in September. There will be fireworks for sure.

These issues will weigh on the dollar in the near term. It has a good chance of going lower in the coming months. Also, take a look at the quarterly chart below and you'll see that the dollar is on the verge of breaking to the downside:

Also, there was a report by ANZ that the net short positions are highest against all major currencies since 2014. One should take heed when this happens. Most of the time the instrument moves lower there might be some short burst of spikes, but in the medium term there is a good chance for the dollar to go lower. True, the last time this happened in 2016 the dollar recovered, but now the political context is much different. That's why I feel the probability of the dollar weakening is much higher this time. The danger is that if the fall is steep, then capital flight is a possibility and that can be nasty.


The recovery can happen if the market senses political stability in the medium term and some key legislation actually gets passed.

Disclosure: I am/we are long INR.

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 hold put options in USD/INR (i.e., short dollar and long rupee).