Over the last couple of weeks, the performance of the dollar has been extraordinary. To the downside, but the move is still well out of the ordinary, particularly given the context. The outlook for the Fed has barely budged, while the dollar index has declined almost 2%. For a currency, that’s a major move, which by itself would be worth talking about.
But, many assets are also priced in dollars, beyond currency pairs. That includes oil, gold, silver and even cryptocurrencies. The unusual movements in the dollar have created unusual moves in a host of other assets. The question for traders now is whether the move will continue, or will the market correct back to its prior trend?
Everyone Gains When the Dollar Falls
The most proximal catalyst to the disruption in the currency markets is the US Treasury’s announcement that it would double repurchases of its long-term debt. That the government is repuchasing debt at all is already a worrying sign. That it has to increase such purchases indicates the situation has only deteriorated.
The high yields on US long-term bonds are a sign that investor are growing concern with US fiscal policy. If the government continues to run chronic deficits, then it will have to find ways to pay for its debt, which are generally negative for investors. Options include raising taxes, which slows the economy and would injure the stock market; and expanding the monetary base, which results in inflation. Essentially, the higher yields represent an increased risk premium that investors are demanding to offset the risk of higher inflation.
So, Is It a Fed Credibility Problem?
If the implication is that investors expect long-term higher inflation, does that mean they are losing confidence in the Fed doing its job of maintaining price stability? Not exactly. The concern is that higher yields will lead to paper losses for financial institutions who hold long-term debt. They won’t be able to collateralize underwater holdings, meaning they won’t be able to operate efficiently as financial institutions. If there is any risk in the system (say, another spike in oil prices), it could cause those financial institutions to go insolvent, creating a recession.
A recession means that the Fed will slash rates, likely resort to QE, and the lack of tax revenue means government deficit spending will go into hyperdrive. All of which means inflation on a long-term scale, even if the Fed hikes rates now to try to get consumer prices back in line.
What Does It Mean For Currency Traders?
The immediate effect is for the dollar to weaken, but also that expectations that the Fed will hike won’t shore up the dollar (at least, not as much). That’s because higher rates drag on the economy, and also push yields higher. If the situation gets worse, the Fed will find itself in a lose-lose situation, where if they don’t hike, there will be inflation; and if they do, there will be a recession and then inflation.
None of this is certain; in fact, the market thinks it’s unlikely. However, the market is pricing in higher odds of a recession, which means the dollar is weaker, while assets such as gold, crypto, and anything that offers an alternative to the dollar are skyrocketing. If the US economy recovers in the second half of the year, then the concern could fade, and the dollar could rise. But, we won’t know for a few months.
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