Normally, all things considered, the country which possesses the most solid fundamentals in terms of monetary policy, economic growth rate, fiscal policy and above all, YIELD or INTEREST PAID on its government debt, tends to have the strongest currency. At least that is the way it formerly was. These are broad principles and while there are always deviations, if two countries were pretty evenly matched in terms of the first three factors, the nation which had a higher yield on its government debt tended to attract more investment flows and thus had the stronger of the two currencies.
When we think about the US Dollar, we certainly do not think of a nation with sound monetary policy (reckless creation of nearly unlimited units of its currency called Dollars). Nor do we think of a nation with a strong economic growth rate (we were reminded of that today with the lowering of the original 1rst quarter GDP number). And lastly, fiscal policy here in the US is an unmitigated disaster given the enormous and never-ending budget deficits and huge amount of overall indebtedness (the US is now at levels on its GDP to Debt ratio of 100% or higher).
Why then the strength in the US Dollar? It is certainly not fundamentally based.
The truth is investors in Europe are terrified of what is taking place over there and have lost confidence in the bonds of many nations comprising the EuroZone. They are yanking their money and moving it into anything but the Euro which is giving the US Dollar the strength it is currently enjoying.
But how exactly is this being accomplished seeing that the US equity markets are sinking like a lead brick? Money flows from abroad are not moving into the realm of US stocks, that is for certain. The answer is that these investment/safe haven flows are moving into US Treasuries. In other words, there is unprecedented demand for US debt and this is producing the rally in the Dollar as all that foreign currency needs to be EXCHANGED (this is why the currency markets are known as FOREX - Foreign Exchange Markets) for DOllars to buy Treasuries with.
We can see this in graphic form by examining the following chart which basically charts the USDX and the Yield on the Ten Year Note and then charts the difference between the two to see whether or not the Dollar is rising as interest rates rise, falling as interest rates fall or RISING even as INTEREST RATES FALL. The latter is of course somewhat counterintuitive from a purely performance based perspective. After all, why in the world would investors deliberately put their capital into the currency of a nation where the yield they are receiving is actually going down?
Quite simply - we are living through times which are unique and unprecedented. There is almost a type of panic-buying of US Debt as a safe haven. Investors are willing to accept a paltry 1.58% on their money for the next TEN YEARS just to get it out of Euros and out of equities.
How this is demonstrated on the chart shows up as you look at the solid blue line. Note that there have been three occasions during which the Dollar has enjoyed great strength even as interest rates have fallen lower. The first was back in the middle of 2008. We all remember what happened then - the credit crisis erupted and there was a mad rush into the "safety" of the US Dollars, mainly in the form of Treasuries. That buying drove Treasury yields lower (remember- rising bond prices means lower yields).
We can see the same thing occurred in early 2010 when there was fear that QE 1 was ending and there was nothing to take its place on the drawing board. The rush back into Treasuries occured once again and up went the Dollar as interest rates were pushed lower by safe haven flows.
This third occasion can be seen to start in April of last year when it was assumed that QE2 was coming to an end in June. Ever since then, with a brief exception in October of last year, the Dollar has GENERALLY MOVED HIGHER even as INTEREST RATES HAVE MOVED LOWER.
This trend has accelerated in March of this year and continues at the present time as fears over the European Sovereign Debt affair have intensified. Notice how wide the differential has become. What this is charting is the FEAR of traders/investors over the preservation of their wealth. It is at an even higher spread than it was back at the peak of the credit crisis of 2008 even though the USDX is some 6 - 7 points lower than it was on both other occasions when this widening of the differential was taking place.
I would venture to say that if we constructed a chart of Yen, it would look quite similar over the last few months.
My thinking is that if the Fed does come in with another round of QE3, and it is of sufficient size to convince market participants that the threat of deflation has been suspended (at least for the time being), we will see the US Dollar move sharply lower narrowing this spread and will more than likely see longer term interest rates actually rise instead of falling as one might assume woudl occur, as deflation talk will give way to inflation talk and money will flow out of Treasuries pushing yields higher in the process.
Time will tell.
