If the Fed is going to begin taking away the punchbowl why is the dollar tanking?

For a number of weeks the Fed has been talking about “tapering” its asset purchases, and from the recent spike in US government bond yields and the decline in US equities it seems as though investors are taking them at their word. This does however raise an interesting question: If the Fed really is going to begin taking away the punchbowl why is the dollar tanking?

The chart below shows the US dollar index, a widely followed index which values the greenback against a basket of foreign currencies. As you can see, for the past 12 months the dollar has been trading in a range between 84 on the top and 78 on the bottom. Late last year however, the index began to form a bearish rising wedge pattern (blue lines) – seen when prices move in an upward direction but the trading range narrows.

In May the dollar ran into overhead resistance at around 84.5 and looked to be about to break out to new highs. This breakout seemed even more likely thanks to comments from various Fed officials in which they spoke of reducing their asset purchase programme as early as their next meeting which is scheduled for 18-19 June.

A reduction of assets purchases from the current $85 billion a month was taken by the market as a sign that the Fed is now in “exit mode” and that the US economy no longer needs as much stimulus from the central bank. The assumption by the market that Fed would now reduce the rate at which it is expanding its balance sheet, and soon begin reducing it, sent both the US bond and stock markets in to a tizzy. However, it also should have been a catalyst for a stronger US dollar, and yet it wasn’t.

Since 23 May the dollar has fallen by 4.6% – a big move in currency circles. The sharp drop also triggered a violation of the bearish wedge pattern, which helps explain the big down day (circled).

A 1 year (daily) chart of the US dollar index (Click on the chart for a larger version)

A 1 year (daily) chart of the US dollar index (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

Why is the dollar falling when it should be rising?

The question is, why is the dollar falling when it should be rising? There is little in the way of US economic news that would trigger such a sharp selloff in the dollar. The data isn’t great, but it’s not terrible either, which means we have to look elsewhere for the cause.

The US Dollar index measures the value of the greenback against a basket of foreign currencies, which include the Euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and the Swiss franc. However, the index is heavily weighted towards the euro (57.6%), while, the Japanese yen and British pound are weighted at 13.6% and 11.9% respectively.

It’s clear then that the first place to look is at the euro. Here we find a perverse situation in which the expectation of a further interest cut by the ECB has caused investors to buy the single currency.

Typically a rate cut is bearish for the value of a currency, since investors will receive less compensation for holding it. However, it seems that investors believe that the rate cut will help economic growth in the region, or at least stem the tide of bad economic numbers, (this is despite the fact that ECB officials see spurring economic growth as the job of elected officials in individual countries). As a result, over the past month, the euro has risen by almost 3% against the dollar.

Other catalysts for a stronger euro include an inflation rate that continues to fall and a central bank balance sheet that continues to shrink as commercial banks repay loans from the ECB.

The US dollar is also susceptible to a rising yen and over the past few weeks that is exactly what we have seen. Over the past 30 days the Japanese currency has risen by more than 7.5% against the dollar, in what was a substantial counter trend move.

Ever since the BoJ announced aggressive QE aimed at weakening the yen and creating inflation late last year, the value of the Japanese yen has been falling against all of its major currency peers. However, the recent dramatic spike in JGB (Japanese Government Bond) yields gave the central bank reason to pause as it made a decision to hold back on expanding its stimulus programme.

The bottom line

In conclusion then, the reversal in the direction of the Japanese yen, together with the recent rise in the value of the euro explains the recent counter intuitive fall in the US dollar.

Short-term fluctuations aside however, in a world of competitive devaluations (aka currency wars), it’s hard to pick a winner among the major currencies. What we are seeing is a race to the bottom and therefore investors need to consider seeking protection in assets such as high quality dividend paying stocks and, longer-term, precious metals.

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