Updated: Sep 7, 2021
The consensus trade coming into 2020 was to be bullish Emerging Markets and to be short the U.S. Dollar. This sentiment reversed because there was a global dollar shortage (Refer to our 'Dollar Squeeze' article) in March 2020 which caused the trading value of the dollar to spike. The federal reserve stepped in to plug the hole that was left by the lack of dollar liquidity and printed a record amount of money in order to reduce the rapid inflation of the dollar. The Fed accumulated more treasuries in March and April then the entire foreign sector did in the last 6 years. The question is did they do too much? And will this hurt the dollar and/or U.S. economy in the long run?
The U.S. lost about 22.2 Million jobs in the months of April and March. The DXY was trading at full value and was headed into deflation due to the shortage of U.S. dollars in the market. The Oil crisis forced the Feds hand into opening up the same credit facilities that were conceived in 2008. The question is how much is too much printing and what effect will this have on the dollar int he years to come?
Definitions / Explanations:
Federal Reserve: The Fed is tasked with controlling the money supply using tools such as asset purchasing (QE) and manipulating the interest rate. Although it cannot print money, it decided how much money the treasury should print in a fiscal year. .
Treasury: Treasury Department's Bureau of Engraving and Printing handles the printing of physical currency but the Fed determines exactly how many new bills are printed each year. Now-a-days the currency system is predominately electronic and a change in the money supply is a few strokes of a keyboard.
Q.E.: Stands for quantitative easing and it is a Federal Reserve run program to help expand the money supply by purchasing securities in the open market. This is done in order to provide dollars to a market that is in need.
The movement of the Dollar since 2008:
The Federal reserve began a policy of QE (Quantitative easing) in response to the 2008 financial crisis. This policy involved the flooding of Dollars into markets in order to encourage productive lending and to promote prosperous economic growth.
2014-2017 presented a new problem to the global economy; deflation. The rise of the dollar was followed by a reduction in the price of goods, assets, and services. Oil fell while Gold and equities skyrocketed.
The Fed began to undue its QE policy in late 2018 in order to reduce the rate of deflation. This had a severe impact on the markets; the dollar created a ceiling at 99 and began trending bearish. The equity markets as well as Oil crashed. Gold had reached its bottom and began the aggressive bull run that we have today.
The dollar sentiment turned bearish following the controversial decision by the Fed to lower the interest rate (Fed Funds Rate) in August 2019.
Dollar was trending lower coming into 2020 and was range-bound inside the 96-99 price range. The Consensus was to be short the U.S. on the back of the Fed Funds rate cut in August 2019.
The sentiment went from a short Dollar bias to a bullish bias in March because of the liquidity squeeze that the world was incurring in U.S. dollar debt. Investors began selling risk assets in order to get dollars and that showed because of the rapid spike in the dollar.
The Federal Reserve uses unprecedented monetary policy tools to reduce the deflation of the dollar and they ramp up their controversial QE expenditure. This action was successful and took the dollar off of the edge of deflation.
The dollar is now trading at pre October 2018 lows and will likely head lower.
There are two schools of thought regarding the dollar:
Dollar Bear Theory
In simple terms: Dollars bears believe that the Federal reserve will oversupply dollars to the open market and cause higher inflation. The debasement of the dollar is intended to provide the government with more money to stimulate the economy using spending and cheap borrowing.
The federal reserve will need over $5 Trillion in new dollars to service the demand for dollars that has been caused as a response to the global pandemic. This unprecedented supply of dollars to the open market (along with record low interest rates) is causing a sharp decline in the dollars trading value (Inflation).
Dollar bears believe that since the Federal reserve has pledged an unlimited Q.E. policy then they will artificially keep the dollar low to reduce debts, increase money supply to the Govt and encourage exports. Dollar bears believe that the rapid inflation of the dollar will reduce the the purchasing power of the dollar and will lead to the replacement of the Dollar as the global reserve currency.
Dollar Bull Theory
In very simple terms; The dollar bulls are making a long term bet that the U.S. Dollar will remain the global reserve currency.
Dollars bulls believe that despite the unprecedented supply of money to the market there will still be higher demand for dollars than other currencies. Dollar bulls reference the amount of global trade that is settled in dollars as the primary reason for the belief in dollar strength. They tend to ignore the level of U.S. dollar debt owned by other countries as an argument against dollar strength.
Our Bias and Why:
The make-up of Dollar debt is as follows:
According to the B.I.S. the U.S. has $53 Billion in total debt. There is $12 trillion in U.S. Dollar denominated debt overseas. Foreign banks get dollars to service their debt from trade. When we had a large trade shutdown due to the pandemic a lot of those countries that rely on trade got cut off from dollars. Of the $12 trillion of foreign owned U.S debt- $4 trillion is in developing markets and the rest of the $8 trillion is held by developed countries.
Foreigners own about $40 trillion in U.S. assets (equities, treasuries) and they sell them when they need dollars.
What all this means is that foreign governments own more U.S. assets than they own debt and most of the dollar debt is owed to the U.S. government. In order to reduce the debt level of dollars the federal reserve will continue to cause inflation (through the dilution of the dollar market through printing).
We believe that since the majority of the world still settles business/trade in U.S. dollars that it will remain the global reserve currency. Regardless of how much the Federal reserve prints we will still see: foreign banks locking those dollars into their strategic currency reserves, Citizens saving more dollars due to availability and risk, corporations use these dollars to buy back stock, and banks use the dollars to increase their lending revenue.
We can expect a decline of the dollar well into the U.S. Presidential election. Whenever the Fed changes their policy to a tightening of the money supply (raising rates and closing the QE facility) then the dollar will sharply rebound back to the 96-99 trading range.
Correlations to watch:
Dollar/Gold: The price of Gold versus the dollar should remain bullish as long as the Federal Reserve pledges to continue its asset purchase program. We can expect Gold to reach well beyond 2,000 and into the $2,200-$2,500 range.
Dollar/Oil: Oil is a counter correlated pair to the dollar. Oil should begin to rebound as the dollar crashes and demand for travel returns. Since all Oil is traded in Petrodollars (U.S. Dollar settlement) it is inversely correlated with movements in the U.S. dollar.
Dollar/Equity: We have noticed a direct correlation between equity runs and decisions by the Fed to increase/decrease the money supply. Don't bet against the Fed. If they say they will print money then expect the equity markets to respond positively since a large portion of that liquidity will return to the equity markets.