U.S. Dollar Strength

Includes: UDN, USDU, UUP
by: WWS Swiss Financial Consulting SA

The U.S. dollar is currently holding up well in forex markets.

Higher interest rates in the U.S. are attracting foreign capital.

U.S. investors are putting money into bonds.

U.S. Treasury bond yields trend lower as a result.

The negative consequences of negative yields for the U.S. dollar.

The U.S. dollar has been holding up well in forex markets. The U.S. dollar index, heavily weighted on the euro, is still in the upper 90s.

Source: Bloomberg

The U.S. dollar is still involved in more than 85% of all forex transactions. The plans of the Chinese and Russians, as well as other countries, to supplant the U.S. dollar as the main global reserve and international currency have so far had only minimal results. That could change very quickly. Future U.S. dollar depreciation should not be discounted.

U.S. Interest Rates

Currently, interest rates for Treasuries are higher than the yields of almost all other central banks globally. The amount of global debt with negative yields has increased recently.

Since U.S. interest rates are higher than in other countries, there is a flow of capital to the U.S. The figures for June 2019 show that there has been a positive net inflow of capital into the U.S. As per Treasury International Capital:

Taking into account transactions in both foreign and U.S. securities, net foreign purchases of long-term securities were $99.1billion. After including adjustments, such as estimates of unrecorded principal payments to foreigners on U.S. asset-backed securities, overall net foreign purchases of long-term securities are estimated to have been $79.9 billion in June.

Lower Yields for U.S. Treasuries

There are various results of dollar strength. Obviously, American companies encounter difficulty in trying to export products produced in the U.S. as their prices are higher when converted into foreign currencies. Foreigners have to pay more to buy U.S. dollars in the forex markets. The higher cost of the U.S. dollar is more than compensated by the higher interest rates on U.S. sovereign debt. The EU has negative yielding sovereign debt, while Japan has been experimenting with invasive central bank acquisitions for years.

It's clear that high demand for bonds causes an increase in the price of the bonds. As the prices of bonds in the market increase, bond yields consequently decrease in an inverse proportion. When investors seek safe havens for their capital and buy bonds, the prices of bonds increase and the yields of bonds decrease. The Fed has little control over longer-term notes and bonds.

Source: CNBC

Source: CNBC

Looking at the two charts above for the 10-year Treasury note and the 30-year bond, it is clear that investors have been buying up long-term paper. If one adds the acquisitions on the part of foreign investors seeking to profit from higher U.S. interest rates since central bank paper in their own countries has negative yields, then it's understandable why long-term Treasury yields have decreased.

Negative Consequences

The Fed now faces serious problems. The inflow of foreign capital accentuates the trend toward lower yields caused by U.S. investors seeking safe havens due to the fear of an oncoming U.S. recession. There is already a global slowdown. The fed funds rate is at present at 2%-2.5%. This means the Fed still has 200 bps for reducing rates before reaching zero. Most other central banks already have negative yielding paper in an attempt to foster growth and keep their economies afloat. The central bankers know that extremely low or negative interest rates put pressure on banks and practically ruin pension funds and cause problems for insurance companies. It seems as if they're willing to take these risks in order to implement ZIRP and NIRP.

In the U.S. it's well known that most pension funds are underfunded and that they based their calculations on an 8% annual ROI. The Fed started raising rates in 2015, but has now changed course. A rate cut of 25 bps in July put an end to rate increases. At the same time, the Fed is going to stop tapering its balance because tapering results in a tightening of credit and less liquidity in the system. This means that pension funds are not going to be able to recuperate and pay the pensions that employees are expecting to receive when they retire. The pension crisis will soon make itself felt.

There is also the consideration that the U.S. dollar is the main global reserve currency, which makes it possible for the U.S. to pay for the import of goods with U.S. dollars. Should the Fed cut rates down to zero in order to reduce the amount of money needed to service the federal debt (now over $ 22.5 trillion) and investors continue to seek safe havens for their capital, yields on government paper will become negative. As a result, foreign investors might stop buying U.S. dollars because U.S. yields had become as negative as in other countries. Such a development could have a deleterious effect on the U.S. dollar's status as the main global reserve currency. That could have disastrous consequences for the American economy.

It therefore behooves investors to follow developments in the bond market very closely. The strength of the U.S. dollar is influenced by what happens in the bond market. In fact, smart investors have already been hedging with bond purchases. At a certain point, if yields go under zero far enough, investors will realize that negative-yielding bonds no longer serve their purposes. The most recent German bond offer with a 0% coupon was not fully subscribed. If foreign investors find that U.S. bonds have zero or negative yields, they might stop buying U.S. dollars for investment in bonds. That could cause the U.S. dollar to weaken in the forex markets. A strong U.S. dollar would have previously, in that case, brought about a fall in global market share for American products, which would be very difficult to regain. So investors should also watch how the U.S. dollar fares in forex markets.

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.