During the majority of 2009 the dollar was heavily swayed by the risk aversion/risk acceptance swings in market psychology. That was why we saw stocks and the dollar generally going in opposite directions. When the markets were nervous they sold stocks and sought the safety of the dollar, mostly meaning short-dated Treasury securities. They the markets were feeling better, especially as the economic data improved, the market go out of its hunker down positions and moved into risk assets like stocks and emerging markets. We can see this very clearly when overlaying the dollar index (black plot, right scale) and the S&P 500 (red plot, left scale) on one chart.
We can also see this when overlaying the price of the 10 year Treasury Note futures on the Dollar Index chart. In this case we can see how falling prices (rising yields) from folks exiting the Treasury market matched up with a falling dollar.
Things began to change with the Dollar/T-Note relationship in the latter part of the third quarter, though, and that really showed up in December’s trading when rising rates (falling T-Note prices) came in conjunction with a rising dollar, and for the first time in a long while stocks and the greenback were consistently rising at the same time.
Why did this change? Because the markets are anticipatory things.
The fall in the dollar, as much as it was a lifting of the risk aversion trade, was also linked strongly to the dollar carry trade (borrow cheap dollars and invest them for higher returns elsewhere) and the Fed’s quantitative easing operations (buying Treasuries and mortgages). Both of those are generally things which increase money supply (whenever someone borrows money supply increases). More money means less value for the currency, which is why quantitative easing is considered a negative.
Two things started to happen in the latter part of the year, though. One was that the Treasury market, especially on the longer end, started getting worried about inflation driven by all the Fed operations. That’s a big part of what caused Treasury prices to fall, especially on the longer end. At the same time, the Fed finished up its program of Treasury purchases, so a big buyer left the market. Less demand means lower prices. This all contributed to the big steepening in the yield curve that’s been so much in the market discussion.
Of course the concern about inflation, combined with an improving economy, has traders starting to think about when the Fed will start raising rates. That wasn’t being asked until late in the year. Now it is, which is why Fed statements and minutes are being so closely monitored for indications. Higher interest rates, especially in the short maturity area, will kill the carry trade and make the dollar more attractive to investors. That is what helped lift it up from the late November lows.
Now consider one more element of all this – the money supply equation. Look at the chart below and make note of the grey M1 and blue M3 lines.
Notice the big growth rates in M1 during the latter part of 2008 and into 2009. That is the result of the Fed’s actions with quantitative easing and its various liquidity programs. The Fed has massively increased the monetary base, which is why you hear about the banks having huge levels of reserves.
Here’s the rub, though. M3 is not only not matching that growth, it’s actually started falling. You can think of M3 as being all the money in the economy, but most notably it includes bank loans. This is the thing people look at when they complain that banks are not lending. If M3 is falling when the monetary base is holding steady or increasing (or rising less than the others) it means that credit is contracting and loans are being paid off.
It is definitely going to be worth tracking money supply in the year to come. It will no doubt be tied closely to when the Fed starts to hike rates and how the dollar performs in general terms. On the one side, if M3 starts to rally quickly the inflation hawks will start screaming for Fed rate hikes and/or other measures to pull liquidity out of the system. Both those things would generally be good for the dollar so long as M3 doesn’t accelerate too fast. At the same time, if M3 keeps falling it will mean fewer dollars in the system. That’s also a positive for the greenback.
Now of course in the forex market it’s about relationships, so what happens with exchange rates will be dictated by more than just what’s happening in the US. Still, the makings are there for 2010 to be a good year for the buck.
Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results.
Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.