One person that has been at the forefront of this argument is the Billionaire Hedge Fund Manager, Ray Dalio, who argues that the continuous programmes of QE employed by the Federal Reserve and low reserve funds rate weakens the value of the USD and threatens its status as the reserve currency of the world. The rise of Bitcoin and the return of strength in Gold have both been touted as possible USD replacements as has the Euro. However, arguably this is perhaps one step too far, the USD is well established across the world as the reserve currency and reversing this would potentially take years if not decades. Furthermore, these instruments are all priced in USD as is Oil. As for the Euro, the EU has also been running similar policies to the US with ultra-low rates and extensive bond buying programmes. So, for now I think it is safe to say the USD will keep this prestigious status.
The return of inflation
The Federal Reserve (Fed) has been able to employ these bond buying programmes and ultra-low interest rates because inflation has been below the 2% annual CPI target set by the Fed. However, as the US economy starts to reopen and pick up steam, prices will rise once again. The question is whether this rise in prices will be temporary or will last longer than currently predicted by the Fed, forcing them to raise interest rates and reign in their bond buying programmes earlier than currently forecast. Such scenarios should see strength return to the USD. However, Jerome Powell, Chairman of the Federal Reserve, has already stepped in multiple times to appease investors of these concerns by saying they expect a temporary overshoot of inflation above their target and therefore rather focusing on inflation to determine when they will start to raise rates they will wait until the economy reaches ‘full employment’, which they predict won’t happen before the end of 2023.
US Dollar Index Chart
How has the USD performed compared to the other major currencies and what potential moves in the market do we see from a technical aspect in the form of the US Dollar Index (DXY):
DXY on the Weekly timeframe dating back to 2014.
I spoke with a Senior Technical Analyst at FXChoice and they provided me with the following analysis on the US Dollar Index; “The DXY has trended down in the last 12 months. It has had some rallies in September last year and March this year. But the pattern has been lower highs. However, it is approaching a critical Support area. Critical Support means a strong support area and an area that, if breached, will have multi-year implications for the DXY. The crucial level is 88.50. What makes this level so important? The DXY came up to this price in 2009 from a low of 71 and was rebuffed hard and fell to 74 by the end of that year. It bounced strongly in 2010 to meet the sellers at 88.50 in June 2010. From there, it slumped fast to 72 in April 2011. After a long recovery, it reached 88.50. For five years the DXY was rebuffed by heavy selling at 88.50.
In December 2014, it crashed up through 88.40 and put six years of trading action below it and now a substantial Support level. In the next two years, it powered ahead as high as 104 but collapsed right back to 88.50 again in Feb 2018. Then the DXY bounced again, almost back to its Jan 2017 high. It fell from there to where we are now at around 90.
We have bounced close to here before in Feb 2018, crashed up though it and soared to 104 in 2015 and been rebuffed by it twice in 2009 and 2010. All this adds up to a very substantial Support level just below where we are right now. This Support level should be a floor for the current USD weakness.
The DXY is falling but is approaching a particularly important Support level which should halt the fall at the very least. Potentially, it could bounce again there as it did at the end of 2017. If it breaks down – the less likely outcome currently – it will be highly bearish for the DXY putting it back into its 2007-2015 range and all the trading since as Resistance. We have to see if the selling pressure weakens at this vital level and how it acts after that. Most likely, it will bounce from a level slightly below current prices.”
The price is currently at $90.77, $2 above the low in 2018 and $14 below the high in 2020 prior to the COVID crisis. Therefore, the USD is sitting near multi year lows and with the signs looking good for the US economy to recover strongly from the crisis which should lead to the Fed to raise interest rates once again and thus increase the value of the USD.
One further thing to bear in mind is how much the US Government has borrowed to drag their economy out of this crisis and what this means going forward. The chart below shows the % of Debt-to-GDP in the US. It is close to 140% as of December 2020 which is the highest level in history and comes at a cost.
As with all borrowing, you pay back with interest. For the US Government this has not been an issue as interest rates (therefore borrowing rates) have been low meaning they can service this debt and borrow more to pay off this debt and so on. However, what happens when interest and borrowing rates increase? This does not only affect the Government; it will impact consumers and businesses that have taken on more debt to survive and the impact it will have on them.
This leads to the question of will interest rates ever return to ‘normal levels’ or will they continue to be suppressed to help service these growing levels of debt. This chart shows the Fed funds rate over time since the 1970s:
As you can see this downtrend of reducing interest rates has been in play since the 1980s, however, we are now at the stage where they cannot get lower without going negative, which has another set of implications.
Therefore, Central Banks are in a dilemma and their only option for now is to keep rates as low as possible (to service the debt and help with the recovery) for as long as possible and hope inflation doesn’t force their hand early to start rising rates rapidly. To conclude, it looks like future rate rises are inevitable and if you feel the US economy is on for a strong recovery and sustained inflation is imminent then we may see strength return to the USD sooner than the market has currently priced in.