U.S. Dollar Stronger As Federal Reserve Moves To Next Stage

Summary

The value of the US dollar has strengthened substantially over the past two- to three-months as the Federal Reserve has continued on its path to raise its policy rate.

In April the Federal Reserve moved into the next stage of its plan to reduce the size of its securities portfolio by removing almost $30 billion.

This reduction, part of a planned $90 billion reduction this quarter to be followed by a $120 billion reduction next quarter reinforces Fed efforts to return to "normal" market relations.

By showing that it intends to "stick" to these plans, the Fed has convinced markets that the dollar is not going to continue to lose value against other major currencies.

The value of the US dollar hit a near term low around the middle of February 2018.

The Wall Street Journal US dollar index closed the day at 82,70. Monday morning, May 7, the index was near 86.50, about 4.6 percent higher than on that earlier date.

On February 1, 2017, it took $1.2507 to buy one Euro, whereas on Monday morning, May 7, one Euro cost only $1.1910. The increase in the value of the US dollar relative to the Euro has been 5.0 percent.

This turnaround in the value of the US dollar has raised a lot of eyebrows, particularly since Donald Trump came into the office of the Presidency talking down the dollar and seemingly supporting a weak dollar to spur on exports.

It appears, however, that the Federal Reserve has taken over center stage as far as the dollar is concerned and is impressing the financial markets with the persistence it is sticking to its intended actions.

First of all, the Fed is staying true to the “forward guidance” it has provided. It has raised its policy rate already one time this year and has given every indication that it will provide at least two more increases this year…if not a third increase.

And, with the current reports on the strength of the economy and the reduction in the unemployment rate, the “data driven” Fed has all the more support for sticking to this path.

But, even more stunning, the Federal Reserve is sticking to its plan to reduce the size of its securities portfolio, a path laid out last summer.

I think that market participants are very impressed with how Federal Reserve officials have kept with their plan in the face of all else that is going on in the economic and financial worlds.

Since September 27, 2017, Federal Reserve officials have overseen a reduction of $105.3 billion in its securities portfolio. This amount take into account the decline in securities premiums of those instruments that have matured during the current program.

Although this is not quite up to the original plan, which put the total at $120 billion through the end of April, it is close enough, given the makeup of the securities portfolio and all the other operational factors the Fed must deal with.

And, to put this total into perspective, the total size of the Fed’s balance sheet in October 2007, just before the beginning of the Great Recession, was right around $900 billion. So the reduction in the sized of the securities portfolio during this period represents an amount equal to 11 percent of the whole Fed balance sheet before the crisis really took place!

What I believe is really impressive is that the reduction planned for April 2018 was $30 billion, a step up from the $20 billion a month reductions that took place in the first quarter. From April 4, 2018 to May 2, 2018, the securities portfolio declined by $28.5 billion, including securities premiums.

This was a huge decline and I think important in confirming the Fed’s commitment to stay as close to the original plan as possible.

One should also note, that since the start of this program, the Fed has overseen a reduction in the “excess reserves” of the banking system, measured by the reserve balances held at Federal Reserve banks, of $187 billion.

Reserve balances held at Federal Reserve banks only amounted to $3.6 billion in the middle of October 2007, before the financial crisis. On September 27, 2017, just before the current program began, reserve balances were right at $2.2 trillion…that is TRILLION.

In the last banking week, the one ending on May 2, 2018, these “excess reserves” dropped below $2.0 billion for the first time in a very long time.

I believe that all this information on the Fed’s balance sheet is confirming the intent of the Federal Reserve, even with all the new Trump appointments coming on board, that the Fed is really going to stick to its path of policy rate increases and reductions in its securities portfolio, which will also reduce the “excess reserves” that are in the banking system.

The bottom line is that the Federal Reserve seems to be really sticking to its effort to get interest rates and bank liquidity positions back to a “more normal” level.

And, these movements are supporting the position of the US dollar. This is particularly true is the face of the European Central Bank delay in turning to a more restrictive policy due to the slowdown in the economic growth of the eurozone economies.

The concern that I have had about the ability of the Federal Reserve to carry out its plans to return to a “more normal” level of interest rates and bank liquidity has been the tax reform and budget programs that have been put into place by the Trump administration and Congress.

With the US economy now in its second longest recovery since World War II, with the unemployment rate being so low, and with the federal deficit and debt burden heading toward historic levels, one wonders how long the Federal Reserve can continue on its current path.

It seems as if the current numbers have given market participants greater confidence that Federal Reserve officials will, in fact, keep on “keeping on” for a while longer.

And, this confidence seems to me, to be the impetus for the value of the dollar staying so strong in world markets.

This situation, however, is one that we need to keep a close eye on. It is a situation that could turn around very quickly, especially if the tax reforms, deregulation, and budget programs impact the economy and inflation more strongly than many now believe they will.

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.