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The day before yesterday, the Fed held a meeting in which, as expected, there was nothing unusual: the risks of a pandemic for the global economy remain, the public debt of the United States is a concern, but in a crisis, the programs Stabilizations launched by the Fed will continue until the financial and economic system will not return to normal.
We have heard nothing new from Fed chiefs and can proceed to assess the prospects for the US dollar. Exactly what is the most important barometer of the state of world financial markets must be understood, and its perspectives will determine whether “risk” will occur.
For the analysis, we will resort to the classical theories of price evaluation of the currency market. Let’s start with the basic one: asset performance theory. This theory is very important in the context of an active monetary policy, since the demand for foreign currency for the purchase of financial assets is the most volatile.
The following image is an illustration of this theory.
The blue line is the real (i.e., inflation-adjusted) return on the US government bond market. USA Relating to a similar indicator among developed countries.
The red line is DX.
We observe a close relationship between the indicators, which is due to the real return on dollar assets: the higher the real return, the greater the demand for dollars. If you look at it from the side of macroeconomic theories, this same dependency has a deeper base: real income growth is possible with an increase in interest rates, the growth cycle of the discount rate, in turn, restricts inflation.
We are now witnessing a divergence of indicators, and the real yield on United States government debt has turned negative relative to the average real yield in developed countries. This signals a bearish outlook for the DX dollar index.
As we refer to the monetary policy of the Federal Reserve, let’s see how soft monetary policy affects the prices of the national currency.
The blue line is the bank multiplier. This is a basic indicator of the state of the banking system, which has a number of interpretations. In our case, it shows the liquidity balance.
A little digression is appropriate here to explain some aspects of monetary theory. Money (liquidity) can exist in the market in different forms, because they have different properties. For example, money in a bank deposit or in the financial market is the most illiquid form of money, but the money in your pocket is the most liquid. To withdraw money from the deposit, you must terminate the investment agreement and they are available in your pocket at any time.
It is important that we understand that there are three basic ways: money in deposits (savings), money in checking accounts and cash. Between the second and third forms, the difference is now blurred, due to the active implementation of the electronic settlement system (the cash in your pocket is equivalent to the money on a bank card).
Rough talking, In the image, the blue line shows the ratio of savings to cash and checking accounts.
We see that when this indicator decreases, which corresponds to the transition of the liquidity state from savings to expenses, the dollar falls (red line) and vice versa.
Below is an illustration of this theory applied to developed countries.
The blue line is the average value of the bank multiplier in developed countries.
The red line (continuing with the blue one) is a forecast model that takes into account money supply dynamics and monetary base indicators in the United States and the world.
The Burgundy line is the DX index in dollars.
In my opinion, the words are superfluous: we are seeing a clear sign that the dollar is weakening.
The stabilization processes initiated by the Fed greatly inflate the regulator’s balance. Let’s see how the growth of the Central Bank balance affects the national currency.
The blue line is the annual dynamics (from year to year) of the Fed balance sheet drawn inversely, since we have a negative correlation between the indicator in question and the dollar index, which is represented by the Burgundy line.
We see that a decrease in the blue indicator puts downward pressure on the dollar index (since there are many dollars in the system) and vice versa.
We conclude our review of monetary conditions by analyzing absorption processes in the financial system.
Let’s remember the theory. We call absorption processes whereby money passes from pockets to savings, reducing the amount of “live” money in the system; Cash shortages lead to an increase in the price (strengthening) of the national currency. Therefore, the processes considered are absorption processes.
In the graph below, the absorption process is indicated by a green line; It includes three basic directions of money outflow from the money market: 1) the Treasury account, 2) repos for non-residents, 3) investments in cash funds. This figure is represented on the left axis, and we see that during the year it grew by $ 2 billion.
The red line is the dollar index.
Obviously, it is precisely the three factors considered that create support for the dollar; until the absorption rate begins to decline, the dollar will be supported.
We examine various principles of monetary theory, but the price of currency is based not only on them. Let’s look at the theory of currency market pricing through the prism of foreign trade relations.
The following image is an illustration of our situation using the terms of trade theory.
The “terms of trade” model is drawn in blue, and the dollar index is in burgundy.
We see that the growth of the dollar does not correspond to the growth of trade conditions, that is, an expensive dollar complicates the work of US exporters.
Of course, fundamental analysis is somewhat reliable, but it has a time frame that distorts the moment of entering into the agreement, and we need to determine when we can work against the dollar.
The fastest way is to build a graph, for which we will have to resort to quantitative estimates and technical analysis; but first let’s look at the market sentiment.
In the image below, the gray area shows my author’s indicator of the dollar index, which is based on market sentiment. The data is taken from COT reports published weekly by the US Commodities and Futures Commission. USA
We see that my model is already below zero and deepens with each week, indicated by an oscillator built into the model and plotted with a black histogram.
Historically, we observed exactly the same behavior of the model under consideration and the oscillator built on it, in 2002, when the DX dollar index was peaking in the long term.
Market sentiment is also against the dollar. We conclude the analysis with a technical image.
I’ll warn you right away: There are many technical models, and if you believe in the theory of an effective market, then all distributions on the market conform to the 50/50 ratio, so each model is equally likely and entitled to the lifetime. It all depends on the personality structure and experience of the analyst.
So, in the image below the daily scale.
In my opinion, the following technical image fits better into the background and fundamental analysis: we are in a state of correction, which, in my opinion, has a good chance of continuing in the “triangle” format. After which we are awaiting the development of a new phase of the dollar index decline with an attempt to break below support at the 94.5 point level.
CONCLUSION
We saw that in many classic models, the dollar has the potential to fall in the near future. Yesterday the Fed said nothing in favor of the dollar; J. Powell’s words make it clear that the super soft policy will continue until the economy stabilizes. This means that more and more money will be invested in the system.
In view of this, I expect a great decrease in the dollar index according to the 2002-2005 model.
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