The Forces that Drive the U.S. Dollar
The U.S. dollar is one of the most misunderstood forces in our monetary system and while most experts have an opinion on the direction of the dollar, very few understand the driving forces behind it. The relative strength or weakness of the dollar has far-reaching implications on the global economy. For investors and money managers who are trying to predict the direction of the dollar, getting it right can lead to oversized profits, while being wrong can lead to major losses.
For most Americans, the U.S. dollar is a green piece of paper we carry in our wallets to use in exchange for goods and services. For foreigners, the U.S. dollar is the onramp to global trade. As the reserve currency for the world, most international trade is conducted in U.S. dollars. As a result, foreign governments and corporations tend to hold large quantities of dollars, so its value relative to other currencies also matters.
Due to the importance of the dollar as the world’s reserve currency, on any given day, financial professionals are openly discussing their view on where the dollar is headed next. The opinions from the financial community vary greatly, without any clear understanding of what drives the value of the dollar. Knowing the direction of the dollar can help an investor make very smart investment decisions.
Take gold for example, which generally trades inversely of the dollar. When the dollar is rising, gold tends to fall and when the dollar is falling, gold tends to rise. There isn’t a perfect correlation between gold and the dollar, but it’s relatively consistent. If one knew the dollar was going to weaken, then they would want to buy gold. And if that same person wanted to buy gold but knew the dollar was going to appreciate in the short-term, they would wait, as gold should fall.
Those who have been long-time clients or followers of my research know I am prepared to be very bullish on gold when the next recession comes. I hold this view for several reasons. When equities crash for the third time in less than 20 years, retirees will likely no longer look towards stocks as a safe haven for their money, like they do now. I believe the Federal Reserve will be forced back into buying U.S. Treasury bonds and Mortgage-Backed Securities to the point where there will be no market for bonds once yields hit zero.
If you find that hard to believe, just look at Japanese bond-yields that have been at or below zero for many years following their failed monetary experiments. With stocks and bonds out, investors will turn to gold, as they always have, when financial markets break. Understanding the driving forces behind the dollar will help me determine when it will be a good time to buy into the gold and silver miners.
Some people believe a weak dollar is good for stocks because it leads to higher exports, but the data doesn’t confirm that belief. Two out of the past three bull markets coincided with a strong, rising dollar. There also isn’t a strong correlation between Treasury bond-yields and the dollar, although there is a tendency for yields to fall during periods where the dollar is losing value. It turns out there is a specific reason for this which I’ll cover later.
Commodities, including gold, tend to do well during periods when the dollar is weakening. Agricultural commodities perform particularly well during periods of a weakening dollar, as a weaker dollar makes our agricultural exports cheaper on the global markets. Many believe crude oil prices trade inversely of the dollar, but not always. While crude oil prices often trade opposite the dollar, crude prices are more a reflection of the global economy. When the global economy is booming, oil prices tend to rise, and when the global economy is weak, oil prices tend to fall.
Just like with interest rates, very few people understand how the dollar works. Most people believe when there are lots of dollars in the financial system, its value falls. This view makes sense, as history books are littered with stories of how governments have devalued or debased their currencies to solve financial problems that caused their currencies to become worthless.
Another view is the dollar must appreciate as the Federal Reserve is actively destroying dollars by unwinding its balance sheet. Logically, this argument makes sense, except when it’s the case that the money supply is continuing to expand despite the destruction of money. While the dollar did rise as the Fed expanded its balance sheet and it is starting to fall as the Fed reduces its balance sheet, there is no long-term correlation that validates this view.
When it comes to currencies, the more money in circulation, the lower it’s of value. Yet the Fed added over $3.6 trillion in excess reserves to the largest banks during Quantitative Easing 1-3, and the dollar appreciated in value. This is evidence that as the world’s reserve currency, the forces that drive the value of the dollar work opposite of how most people think it works.
Whenever I’m trying to figure out a correlation, I like to start with a chart. I pulled the chart of the trade-weighted dollar, or a weighted average of the foreign exchange value of the U.S. dollar, against the currencies of a broad group of major U.S. trading partners, from the St. Louis Federal Reserve FRED database. A chart can help me visually see a pattern associated with another chart. In the case of the dollar, what I saw didn’t help.
Going back to when President Nixon took the United States off the gold standard in 1971, the dollar tended to rise during one expansion, only to fall during the next. Since stock prices rise during expansions, there is no long-term correlation between stock prices and the dollar. Overlaying 10-year Treasury yields confirmed there is also no long-term correlation between the dollar and Treasury yields. I even compared the Federal Funds rate to the dollar, which showed a tendency for the Federal Funds rate to follow the dollar. I believe the Federal Funds rate moves more in response to the movement of the dollar than it causes the dollar to rise or fall.
This led me to ask one very important question – how are dollars created? The Constitution prohibits the Federal government from creating money, so they can only borrow money from those who already have dollars. The Federal Reserve Act of 1937 prohibits the Federal Reserve from creating money. The Fed can only raise and lower the Federal Funds rate and raise or lower the amount of excess reserves in the banking system. Only banks can create money and the large commercial banks create the most money since they originate the largest amount of loans.
When I overlaid the amount of commercial and industrial loans, in billions of dollars, against the trade-weighted U.S. dollar, a correlation appeared. Very few correlations are perfect, this one is no exception, due to the inherent lags in the monetary system. The graph shows that as commercial and industrial lending increases, so does the value of the dollar, and as commercial and industrial lending decreases, so too does the value of the dollar.
There is a tendency for the dollar to rise into and shortly after a recession, which many believe is due to the U.S. dollar being used as a flight to safety, but the dollar didn’t rise during the 1973-75 or 1990-91 recessions. During the 1973-75 recession, commercial lending slowed and during the 1990-91 recession, commercial lending contracted. This seems to support my view.
The lag between the change in commercial lending and the dollar can be as short as a couple of months or as long as a couple of years. By adjusting the chart to reflect the dollar versus the year-over-year rate-of-change in commercial lending, it shows a much tighter correlation. When lending growth slows or contracts, the dollar is soon to fall and when lending growth increases, the value of the dollar will too rise.
While our monetary system is far from perfect, it is self-regulating. Just as interest rates rise and fall to compensate for money-printing inflation and deflation, the U.S. dollar rises and falls to compensate for increases and decreases in lending. Since banks are the only entities that can create money in our economy, as lending increases, more dollars are being created.
The value of the dollar rises as lending increases to soak up those newly created dollars. When the dollar is worth more, investors tend to hold on it, rather than lend it out. As a result, a stronger dollar in response to an increase in lending is our monetary system trying to self-regulate—by slowing down the credit-creation mechanism of our banking system.
The Federal Reserve has been actively trying to slow down the credit-creation mechanism in our economy by raising the Federal Funds rate, or short-term interest rates. Borrowing costs rise as interest rates rise, which slows down the demand for new loans. The Fed is also reducing the amount of excess reserves in the banking system, causing the monetary base to fall, which is highly correlated to asset prices. As asset prices fall, the amount of money that can be loaned against those assets fall.
One aspect of the charts does stand out – when the growth-rate of commercial and industrial lending contracts, the dollar falls. In December 2016, just as the Tax Cuts and Jobs Act (TCJA) was passed, commercial and industrial lending nearly contracted. While President Trump may want a weaker dollar, the TCJA increased the growth-rate of commercial lending which caused the dollar to appreciate.
Currently, the dollar is foretelling a big increase in commercial lending, but with the Fed raising rates and unwinding their balance sheet, any rise in the dollar should be considered temporary. With the year-over-year growth-rate of commercial lending at a weak 6.35%, it is only a matter of time before the Fed causes lending growth to further slow and contract.
When lending growth contracts, gold should enter its next Bull market. During the next recession, due to the massive asset bubbles created by global central bankers, commercial lending, along with the dollar, should enter an extended multi-year decline. This indicates gold should enter a raging Bull market and those with dollars will buy gold to protect their purchasing power against a weaker dollar. Treasury yields, which aren’t correlated with the dollar, will also fall as hedging costs for foreign investors fall.
Foreign investors and corporations prefer to buy U.S. Treasury debt, but when the dollar is strong, currency hedging costs make U.S. Treasury debt unattractive. As the dollar falls, foreign investors will buy Treasuries, putting pressure on all the speculators who have been shorting Treasuries. The combination of a weaker dollar and a short-squeeze in Treasuries should see Treasury yields reach new all-time lows.
Understanding what drives the value of the dollar tells us the economy will weaken as the growth rate of commercial lending peaks and as the stimulative effects of the TCJA fade from the economy. When commercial lending contracts and the dollar falls, asset classes such as gold and agricultural commodities are likely to soar higher. Now you know why the “Smart Money” has been betting the dollar is going to fall, agricultural commodity prices are going to rise, Treasury yields are going to fall, and gold is going to rise. It’s all a function of the Fed tightening monetary policy that will lead to further slowdowns and eventually a contraction in lending.
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Daily Market Briefs
- Thoughts from the Weekend
- What happened to the stock market on Monday?
U.S. stocks were down big today as news broke from Apple’s suppliers of weaker-than-expected demand for the new iPhones. The S&P 500 failed to move over 2,735, a key overhead resistance level, which is setting up a retest of the support level at 2,600. Should 2,600 fail to hold, there will be a much larger move lower.
The DJIA closed back below its 200-day moving average and is setting up a move lower to test a prior support level around 23,600. Tech stocks got hammered as the Nasdaq-100 was down over 3%. Many of the big tech names are now down 20% or more from their peaks, which indicates they are in a bear market.
Treasury yields were down a little today as short-sellers hold on to their belief that inflation will take yields significantly higher, as lending demand continues to fall. As yields move lower and start flushing out the short sellers, yields will eventually make a rapid move lower. The next support level for 10-year Treasuries is at 3%. If broken, the next major point of support is 2.8%.
Physical gold and the gold miners tried to rally today but failed. Agricultural commodities started the day lower but managed to close over both of its 50- and 100-day moving averages on low volume – a positive sign that the sellers are exhausted.
Look for further selling in the equity markets tomorrow as today’s drop in equity prices is likely to trigger another round of deleveraging from the CTA/Quant computer models.
- What happened to the stock market on Tuesday?
The margin calls went out early this morning as Futures and Forex (currency) traders got hit with delinquency notices. An insider reported that traders were selling their winners to buy their losers. Should stocks fail to rally, retail investors will get hit with margin calls tonight.
Housing starts increased 1.5% MoM after September’s starts were revised lower. Housing permits fell 0.6% MoM after September’s permits were revised higher. Survey data shows prospective buyers are priced out of the housing market and are canceling their buying plans.
Crude oil is being sold heavily today as quantitative- and momentum-based computer programs are selling, according to a report from the quant desk at Nomura.
The U.S. dollar popped higher today, which send agricultural commodities lower. With signs of the dollar peaking and agricultural commodities bottoming, it’s only a matter of time before agricultural commodity prices enter a bull market.
Stocks closed lower again as the S&P 500, Nasdaq-100 and Russell 2000 are all in corrections, which is indicated by a -10% or lower move from a recent high. Only the DJIA remains above correction territory. Most of the major indices are very close to giving up their entire returns for the past 12 months. Trading volumes were on par with the past few days, which is not indicating any form of mass liquidation. Investors are holding on to their belief that stocks will soon go much higher.
Treasury yields were down slightly as investors are holding to their conviction that interest rates are headed higher, yet they can’t see their bets on higher interest rates are chocking out the economy. Investors are blaming the Fed when they are just as much a part of the problem.
- What happened to the stock market on Wednesday?
Durable Goods orders fell -4.4% MoM, but when stripping out the volatile defense spending, orders were up +0.1% MoM. Crude oil inventories came in higher-than-expected at with a +4.85-million-barrel build. With refinery maintenance season ending, many believe the inventory levels will fall. U.S. production remains at record high levels.
The final data from October’s University of Michigan buying intentions survey showed falling intentions for houses, vehicles, and durable goods. Not a good sign going into the critical holiday season.
Existing home sales slowed to 5.1% YoY growth rate after posting a +1.4% MoM change. Higher prices and higher interest rates are slowing demand for housing.
The S&P 500, DJIA, and Nasdaq-100 all closed higher on the day since they all ‘gapped’ up at open, but traded lower on the day. The Russell 2000 started the day lower but closed higher. Treasury yields moved higher on the day to test an overhead resistance level and found buyers, which caused yields to close higher, but trade lower on the day. Today’s reversal in yields is a positive sign that yields are likely to head lower.
All U.S. markets are closed tomorrow for Thanksgiving and will reopen at normal times on Friday.
- What happened to the stock market on Thursday?
- What happened to the stock market on Friday?
Black Friday came to the stock market as investors eagerly bought stocks in early trading, but by market close, all major indices except for the Russell 2000 closed lower. Treasury yields fell to a prior area of support and the short-sellers defended on very weak volume.
Eurozone flash PMIs are showing signs that the Eurozone manufacturing sector is rapidly slowing and near contraction. After trillions in monetary support, the global economy remains weak.
Crude oil had a bad day, closing nearly -6%, which is a sign of what is to come for the broad stock market. When oil falls, so too will stock prices.
Agricultural commodities saw aggressive overnight selling as the dollar strengthened. There was a report out of China yesterday on how they are purchasing soybeans from other farmers, yet the quality and size of the beans are well below U.S. standards. Most of China’s soybean imports go to feed livestock, particularly hogs, which is foretelling lower livestock production in the coming year. At some point, the world will be forced to buy U.S. agricultural commodities as there is not enough production to supply the world without us.
After hitting a strong level of resistance, the gold and silver miners fell today. There is a definitive battle between the buyers and sellers, with neither side having the upper hand.