What's Next for the U.S. Dollar?

by: David Andrew Taylor

Last week, I wrote about the pending fall in the major currencies vs. USD, and a subsequent fall in oil and other commodities.  As the charts below show, EUR precipitously crumbled 6 big figures last week, along with all the other major currencies.  As well, oil is down another $6.00 for the week. 

click to enlarge images

The question I asked myself going into this weekend:  Is this move for real?

The short answer is: Very.

The long answer is: Absolutely.

The thing is, what we saw the past week isn't even the appetizer for what's up next.  It was more like the  hors d'oeuvres passed around as participants are just starting to stroll in to the USD rally dinner party....  And it's gonna be a big feast.  

To understand, we must first look at two things:  First, how do I look at markets, and second, to know where we are going, we might need to know where we've come from.

When I look at economics, I start searching for balances and imbalances.  Imagine a seesaw.  This is the ultimate in balancing mechanisms where children push themselves up and down, counterbalancing each other.  

For economics, seesaws are no different.  In the perfect world, Central Bankers are always striving to achieve that perfect balance where growth and price stability are in line with each other, and the seesaw is never tilted in favor either way.  No hard task.  Sometimes growth gets imbalanced with price levels, and vice versa.  If you let an imbalance get out of hand, it's going to pick up a tremendous amount of momentum, until it gets stretched as far as reasonable limits will allow.  

Ben Bernanke has said that if you want to understand a country's economy, you must start at the single most important economic event that country ever had and move forward from there.  For the U.S., that would be the Great Depression.  

For us, and the purposes of trying to figure out where we are going next, let's look at the biggest imbalance imaginable:  When interest rates were sitting at 1.00% for far too long.

Overly lubricated interest levels were absolutely the root of our current economic malaise.  With interest rates as low as they were, two major shifts in our countries economy began:  First, money started to flow out of this country in favor of higher yield elsewhere.  Second, ultra-low interest rates spurred a housing boom that would ultimately go bust.  

Having interest rates so low for as long as we did created a tremendous imbalance, to say the least.  Having such loose policies enabled far too many individuals to reach way beyond their means with nary a check on whether it was a sound investment.  Now that the loose policies aren't around, large segments of those that participated in the boom are going bust;  home owners, banks, builders, investors and anyone else with their hands in the cookie jar are getting slapped.  Unfortunately, the ramifications are far reaching and a domino effect is taking hold.

Imagining the seesaw as a visual, when we have an imbalance, one side is either too far high, or too far low.  In this particular imbalance, the housing boom, we have one child all the way down on the ground, and the other one high up in the air.  And in this case, the kid that's on the ground just got off the seesaw, sending the other kid crashing to the ground.  

This scenario represents the ultimate in an imbalance, being stretched as far as possible to one side, and the subsequent crash to the other.  Where there was once euphoria, where nothing could possible go wrong, now we have the complete opposite.  That's what happens to imbalances that are allowed to go too far.  Look no further than these prime examples:  Tulips and Dot Coms.  The housing boom of the early 21st century will now be written into the great big book of Bubbles and Busts.

One imbalance undone.  Many more to go.

Another imbalance:  As the USD eroded, the price of oil went up respectively.  Oil's price is derived from two sources:  Overall demand, and the underlying value of USD vs. the host country's exchange rate.  Now that world growth is slowing down, demand for oil will slow, and perhaps refining capacity will catch up with new investment.  And, as long as the USD continues to move higher and higher vs. its counterparts, the price of oil will fall.  

Another imbalance down.  More to go.  

Price instability is making headlines all over the world as the surge in basic commodities is starting to permeate throughout all aspects of our economies.  There's been a tremendous surge in demand from both China and India as their economies are transitioning into a more sophisticated society.  These large, and mostly uninterrupted, demands on basic resources are weighing heavily on the "system's" ability to keep up, and the large increases in prices are affecting aggregate demand.  The world's largest economies are slowing dramatically from the credit collapse as well as the consumer's inability to navigate through these choppy waters, and with that, the commodity indexes are starting to retreat as rationality enters into the fray.  It's not to say that basic prices are going to retreat to lows we knew so well just a few years ago, as it is to say that the commodity boom will see a huge breather, and then moderation.  

Another imbalance down.  Still more to go.

The biggest major imbalance that was in place was the flow of funds in search of high yield.  Money was flowing out of Japan at breakneck pace heading all over the world getting spreads as much as .05%/8.25%.  Why would you invest in Japanese bonds when the interest rates were down so low (0.05%) when you could get yield as high as 8.25% out of New Zealand?  You wouldn't.  And so, billions upon billions upon billions were printed by the Bank of Japan to spur its dead-end economy, only to instantaneously leave the country in search of higher yield.  All that money exiting the Japanese economy so quickly after being printed,  no wonder Japan is stuck in neutral, on a hill, starting to drift backwards downhill.  

If you recall my article last week, all currencies are quoted in USD and flow through the same to promote liquidity:  If you want to invest in buy AUDJPY, you must sell JPY for USD and then sell USD for AUD (It's a mathematical calculation that's done instantaneously). 

So, along with the JPY, the USD played "Monkey in the Middle", and got whittled away in value as  banks, investors and countries that once preferred investing in U.S. debt headed out in search of higher yield. 

This imbalance has yet to capitulate....  But, it is the next victim.

I've searched and searched as best I could through my resources at banks, brokerages and news services.  The message is all the same:  The dollar's rally last week is real.  

This is August.  We're in the dead of summer, which means typical flow is light as most of the Northern Hemisphere would prefer their margaritas and lime with chips and salsa over bid/offer spreads.  But the flows seen this week were large.  Very large.  

For me, there are three things that affect markets:  The fundamentals, the technicals, and market psychology.  

We're seeing a very real move of "real money" players exiting en masse and flowing back into the USD.  The fundamentals all support a move out of the "yield chase".  The ultra-profitable carry trade was based on a yield differential between Japan, the United States, and the higher yielding target countries.  Yields in these countries are expected to come down with dramatic fashion, and FX traders are in high gear to be the first out, capturing as much of their hard earned profits as possible.  

Central Banks are looked upon as being way behind in putting on their work boots and getting imbalances in line.  If interest rates are left too high too long, it will be viewed as the death knell for economies as we've already seen dramatic decreases in demand and growth, while simultaneously commodity prices are falling precipitously.  

This week, we see several economies reporting inflation on some level or another, to include: The United States, The United Kingdom, Australia, New Zealand and the Eurozone.  In every instance, whatever the release, it will be "damned if you do, damned if you don't".  If there's a drop in inflation, the corresponding currency will get pounded...  After all, more room to lower rates.  If there is an increase in inflation, which is widely expected out of every nation out there, then the currency will likely get pounded as the only cure for inflation at this point is to starve said economy to death with higher interest rates only to bring them dramatically lower later.  And that's just it:  These economies are already slowing, and commodities are already starting to fall.  

As much as the USD rallies, and pushes commodities lower and lower, price pressures will do the same.  And, as quickly as economies contract, price pressures will abate as demand shifts.  At some point, the world's Central Banks are going to be rushing to lower rates to catch up with the curve.  And as available liquidity continues to dry up in these countries, growth goes the same way, and Central Banks will be chopping away at their interest rate levels running their printing presses creating money for the system.

But, for those Central Banks that waited, it will be too late.  Look no further than two weeks ago when the Bank of Canada surprised the world with an influx of liquidity of $800 million, the first need to do so since April.  And the ECB?  On Friday they provided €25 billion of liquidity... filling only 25% of the €100 billion that was bid for.  Countries are seeing massive liquidity shifts. 

While every country out there approached the credit crisis with a modicum of caution, the United States approached the same with a tremendous sense of urgency.  These other major Central Banks are going to be  viewed as being behind schedule.  Interest rates and inflation are going to be looked at on a more forward thinking basis, instead of what you can get right this very second.  Savvy FX traders are known for such acumen.  Right now?  Who cares about today's spread rates in interest.  What's important is that at some point very soon, Central Banks are going to be dropping their shorts trying to pick up their economies from their current stranglehold, trying to provide liquidity to fill the void of missing liquidity as their own banks see funds leaving en masse. 

Last week's comments by Trichet nailed the EUR when he acknowledged growth in the Euro-area will drop significantly the rest of this year.  However, the ECB's only edict is price stability.  Instead of looking at the drop in future growth and oil's drop of 20% in price (a technical bear market), the ECB is required to strangle its economy to achieve price stability.  The Euro-area is going to suffer needlessly, and on a large scale, in the process.

On a technical basis, EUR is sitting on yet another ledge, about to slip off further and deeper into the abyss.  Any support we've seen so far has been shattered last week with only the slightest of pauses.  There was supposed to be major support at the 1.5300 level since the currency bounced twice with a great deal of authority.  This week, that support lasted about 3 minutes.  Now, any hope of a bounce lies with 27 pips as we sit just above the 1.5000 level.  If this level falls - as every other level this past week has - then the move lower will be bigger and even more pronounced - yes, even more.  

What will it take to push EUR lower?  Look no further than the simultaneous release of Euro-area inflation and GDP Thursday.  If there's a slight waiver in growth, EUR will be sunk.  Fact is, though, we're likely to have already crossed the 1.5000 level before then.  It's this looming magnet that has no chance of being avoided.  I'm expecting nervous Asian traders to hit the offer button at the open tonight to start the next leg of the slide.

Other currencies? 

How about AUD?  At the outset of the Asian session today, we get the Australian Quarterly RBA statement.  Here's a nice reiteration that interest rates are going down at one of the highest yielding countries.  AUD will follow, and will send NZD lower along with its own earlier release of housing data out of New Zealand that will confirm the economy is slowing there.  Boom.... the two highest yielding currencies drop even more.

On Wednesday we'll get the Bank Of England's Merv King speaking about his take on the economy.  That should be all roses.... and sell buttons on terminals all over the world as he acknowledges much slower growth coupled with high inflation that will eventually come under control as prices abate.  Boom..... the GBP gets another haircut.

My take on the carry?

All three factors are in play on a large scale to see the carry trade collapse.  The fundamentals show the shift in interest rates that are the key to the carry.  The technicians have been studying the break in trend lines all weekend and are ready to pounce.  And the psychology?  FX traders are sharpening their machetes getting ready to create the very blood in the streets that will strike fear in to those that are too big and too slow to move rapidly.  

As I mentioned, getting in to the carry trade requires selling JPY for USD, and then selling USD for the currency you prefer.  The past couple of weeks, 1/2 of the equation on the USD's sell side has started to reverse from its multi year long decline.  And all of that has the carry trade sitting precariously on the ledge, as well.   

There's an estimated $1.5 trillion invested in the carry trade.  I imagine a carry trader walking out to the Golden Gate Bridge, attempting to bungee jump off.... using a piece of dental floss. 


If you were to look at the JPY cross rates (above), every single one of them has either come down in a pronounced fashion, or is sitting right on its last best hope for a bounce... all this despite the tepid moves higher in USDJPY.  At some point, investors that have profited on a tiny interest rate differential overnight are going to start losing significant money based on the currency values.  And that's when the real slaughtering in the FX markets begins.  

FX traders are NEVER the last ones to leave a party.  We front run everything.  We now know that there is a huge and dramatic shift taking place with interest rates around the world.  If your trades are based on a wide interest rate differential, and that is now being narrowed, the fundamentals are eroding... and so are your profits.  

Slightly nervous traders who depend upon stability are now feeling two emotions:  Fear and hope.... Hope.... as in I hope I don't lose any more as these currencies continue to move lower.  

I'm putting a lot of weight into the 1.5000 level, and a few pieces of economic data coming out this week.  If that level goes, so goes the carry.  The moves were so pronounced and real last week that there aren't many out there realistically expecting a bounce.  If there is any kind of bounce, it will be met with offer buttons on terminals around the world. 

And in comparison to last week's moves in oil, the equity markets and the USD, the blood in the streets from what's next is going to be even bigger...

Even louder...

And even more pronounced.