Dollar Squeeze

Anyone following the FX markets would have noticed the bullish sentiment in 2019. The dollar strengthened on the back of emerging market weakness and trade tensions in 2019 and in 2020 we're seeing the dollar rise due to European fragility, Japanese weakness, and global uncertainty. There are plenty of factors that are impacting the value of the dollar and its not clear how they all play into each other. In this article we'll focus on the major factors impacting the dollar as well as covering the impacts on the currency/comodity markets.

First lets list out the possible fundamental influences on the dollar:

- The Federal Reserve (Rate changes)

- Global Uncertainty (Supply/Demand)

- International Trade

- Health of the U.S. Economy

- Fears of Recession

- Stock Market performance

- Treasury Operations

Now lets discuss these individually before we talk about effects on the market.

First, lets address the federal Reserves role in the value of the dollar. The Fed has long stated that its purpose is to ensure price stability, wage growth, and inflation. The Federal reserve is supposed to be a non-partisan agency independent of the Government. After the 2008 financial crisis the federal reserve took on a bigger role which is to manage the inter-bank system. The Fed now has power over liquidity requirements (making the banks hold cash with the fed to ensure they're ready for another crash). The Fed also heavily controls monetary policy (The act of influencing the money supply), not to be confused with Fiscal policy (laws/tax laws around money). Both policies produce results that affect the value of the dollar, however, the Fed's monetary policy operations have taken the front seat in control and stabilizing the price of the dollar.

The Fed uses 3 main tools to impact monetary policy:

1) Interest rate hikes/cuts

2) Repo Market operations (Repurchase)

3) Reserve Requirements

The Federal reserve has just announced an additional interest rate cut at the time of this article (3/4/2020). This means that borrowing money from he Fed or its member banks should be cheaper, hoping to stimulate the market by making it easier for money to move around. The negative side is that lenders will be less inclined to lend money if they cant get a decent return on it, so they hold it. This is the tug-of-war that the Fed must deal with.

As they run out of room to keep lowering rates (Since we're almost at Zero, meaning free money), the Fed will likely turn to Repo Operations. These open market operations mean that the Fed will offer to buy securities from sellers who agree to repurchase them in the future (like an I.O.U). This works in flooding the market with cash (liquidity) which can provide a boost to markets. The negatives of this operation is that the more dollars are available the less valuable each dollar is, meaning a weaker dollar (supply/demand).

As recession fears grow more prevalent with the onset of CoronaVirus the Federal reserve will no longer be able to do what they normally do which is cut rates. Usually the Fed will lower rates, stimulate the economy with cheap money, promote small business lending, and promote the movement of capital. Now that they've brought the interest rates down to almost 0 that means that they will have to take additional measures to ensure the stability of the dollar if a recession hits. This could ave a major negative effect on the U.S. economy.

International weakness has been a prevalent topic in markets for the past several years. Europe has been struggling with debt crisis, baking crisis, manufacturing recessions, and social unrest for the past several years. Europe's economy is currently trying to stabilize while implementing their new negative interest rate strategies. This weakness in the region, now combined with ongoing threats of coronavirus in Italy, could lead to a slowdown in economic activity. The result of a weak economy is that investors will look somewhere else to put their money in the meantime; mostly the U.S. Dollar. The dollar will act as a safe haven currency if the value of the Europeans domestic currency weakens.

We know that if there are more dollars available in the market then the value of the dollar will drop. So in an environment where the federal reserve has to start buying securities in the open market to give the markets a boost the value of the dollar should drop.

The other perspective is that big investors will be chasing the best (safest) return in the world so even if there are low interest rates in the United States they can still make more money than in Europe or Asia. If a lot of investors flood in to buy Dollars then the value of the dollar will rise.

Now remember that FX is a RELATIVE game. Currencies move only in relationship to a change in price of another currency. So as banks, central banks, and hedge funds sell off their less desirable currencies to buy the dollar, the value of the dollar will skyrocket as a result. A bullish dollar scenario would depend on the global economy's resilience to dealing with ongoing social/political/economic problems.

China's economy is currently experiencing a major halt in their manufacturing and production due to the massive impacts of Corona Virus. For the second month in a row their numbers are down 80-90%. This is in addition to the massive trade dispute that they're were having with the United States. If this continues it will begin to impact the supply chain of businesses that rely on Chinese manufacturing and production. Germany was also experiencing a manufacturing slowdown related to automobiles. Germany is one of the largest economic powers that make up the European Union countries. The impact of the German economy is critical to a weak Europe that is still dealing with the loss of Great Britain. Corona virus has just added fuel to the fire in Europe by affecting of of the other largest economies in the EU, Italy.

As this economic impact spreads investors will look to the dollar to be the safest currency so in this scenario, Bullish dollar.

The bearish scenario would be as a result of an economic recession in the global economy that results in the United states having negative interest rates. If the Federal reserve continues to cut rates and then there's a recession, their only option would be to flood the market with cash through Repo operation to attempt to revive the economy. Overflow of dollars combined with cheap prices is a recipe for a weak currency.

Disclaimer: This paper is the result of the analysis carried out by analysts associated with ChartAddicts. The article does not purport to represent the views or the official policy of ChartAddicts. This is not investment advice.