In October 1991 developments were in motion to create what Bob Case, then deputy meteorologist for the National Weather Service, called “the perfect storm,” which rocked the northeast and sank the Andrea Gail and its six crew members. A book was written about the storm in 1997 and a movie followed in 2000 chronicling the Andrea Gail’s final hours. Mr. Case highlighted the confluence of three factors that made the monster storm, which were:
- Warm air from a low-pressure system coming from one direction,
- A flow of cool and dry air generated by a high-pressure from another direction,
- And tropical moisture provided by Hurricane Grace.
We appear to be having another confluence of three powerful factors that are creating a perfect dollar storm, driving the currency higher. They are:
- Scottish independence driving the British pound lower.
- Expansion in ECB monetary policy pushing the euro lower.
- The yen weakening to a 6-year low to the USD in anticipation of future BOJ action.
From a low in May to its recent high over , the dollar index has rallied nearly 7% in a near vertical fashion as these three major currencies have weakened against it. As you can see below, the euro makes up 57.6% of the dollar index with the Japanese yen coming in second at a 13.6% weight followed by the British Pound with an 11.9% weight.
Source: Bloomberg
All three major currencies are declining relative to the USD which has sent the dollar index up in a vertical fashion.
Source: Bloomberg
Given the sizable weight of the euro in the dollar index (57.6%), a further look at the euro appears warranted. In a world of zero interest rates, interest rate differentials are playing a lesser role in determining currency exchange rates while the size of central bank balance sheets plays a major role. This is made abundantly clear when viewing the relative size of the Fed’s balance sheet to the European Central Bank (ECB) in relation to the euro/USD exchange rate which is shown below. As you can see investors are discounting that the ECB’s balance sheet will expand at a faster rate than the Fed’s.
Source: Bloomberg
ECB President Mario Draghi indicated a goal of returning the ECB’s balance sheet back to 2011 levels, which was near three trillion euros, or roughly 30% higher than today. The future expansion in the ECB’s balance sheet will send ripples throughout the global financial system and it should not be overlooked as the euro makes up 24.5% of total foreign exchange holdings. Given this will be the second major expansion in the ECB’s balance sheet since 2009, a look at the 2011 experience should prove insightful.
There is a lot of data shown in the figure below so bear with me as I explain what we are looking at. The top panel shows the ECB’s balance sheet while the middle panel looks at the US stock market (S&P 500, black line) and the European stock market (Euro Stoxx 50, red line), while the relative performance of the S&P 500 and the Euro Stoxx 50 index is shown in blue.
Source: Bloomberg
We can take a few observations from the 2011 expansion in the ECB’s balance sheet. The first is that the European stock market stopped declining and stabilized while the US stock market rallied higher and outperformed European stocks. We also saw a significant bottom in the USD Index and top in the CRB Commodity Index. The strong move higher in the USD and decline in commodity prices saw the US Consumer Price Index peak in 2011 near 4% and fall close to 1% a year later. The decline in inflation and energy prices in particular was like a huge tax cut for the consumer and fueled stronger growth and higher stock prices.
USD at a Critical Juncture
Viewing the USD technically shows the currency is now at a critical juncture similar to where we were in 1997. Specifically, it is near the upper end of a declining trend line that has been in place for nine years since the 2005 top and on the verge of breaking out. Once breaking through its eight year declining trend from 1989 to 1997, the dollar rallied 50% until finally peaking with the tech bubble. Should the USD break out this time around, it is quite likely to have a strong bullish run going forward.
Source: Bloomberg
While the USD Index is heavily weighted towards the euro (57.6%) and could simply be viewed more as the USD/EUR exchange rate, a look at how the other currencies are performing against the dollar shows the recent strength in the USD is more than due to weakness in Europe. This is borne out in the table below which charts the relative performance of 30 different world currencies and four different precious metals across several time frames. As you can see, the weakness in foreign currencies relative to the USD is broad-based and suggests the move higher in the USD is more than just a weak euro.
Foreign Currency Relative Returns to USD (As of 09/09/14)
Source: Bloomberg
Several Fundamental Supports for Higher USD
The strength in the USD is not just coming from weak foreign currencies, but also for fundamental reasons like a breakout in interest rates. Shown below is the dollar index and US 2-yr government interest rates. The 2-yr US Treasury yield has pushed through the 0.50% level, which has held in place since the 2008 financial crisis and looks set to head back to levels not seen since 2005-2006 near 1.5%-2%. A move higher in interest rates would make the USD look attractive relative to its peers and push it even higher.
Source: Bloomberg
The much improved petroleum trade balance in the US is also lending support to a higher USD as it sits near decade highs.
Source: Bloomberg
A closer look at energy production and imports shows US crude oil production (blue line below) at the highest level since 1987. The surge in domestic production has pushed crude oil imports (red line below) to their lowest level since 1997. This improved energy trade balance, which has helped shrink the trade deficit plus the shrinking of the US budget deficit (black line below), are powerful forces pushing the USD higher.
Source: Bloomberg
Click here to read Part Two of The Perfect (Dollar) Storm – When Currencies Collide, which takes a look at investment implications of a USD breakout and near-term considerations.
