When discussing the US dollar in the past, we have pointed out that one must keep a close eye on certain indicators that tend to give early warning of an impending rally – more on this follows further below. The reason why we are taking up the topic again is that the recent aggravation of Greece's government debt woes has once again directed a spotlight on the problems euro area banks face in obtaining dollar funding. As we noted in 'Greece Continues to Pose a Major Risk', there have been growing concerns about the exposure of US money market funds to euro area banks – which has not only resulted in money market funds cutting said exposure in recent weeks, but has also led to outflows from institutional money market funds, as Barron's reports:
“Concern about Greece and other sovereign debt issues spurred large institutional investors in money market funds to pull their money at the fastest pace in 15 months, according to iMoneyNet.
So-called prime institutional money markets — the type with lower fees and big upfront requirements used by large investment funds and managers — lost $39 billion to net withdrawals in the week ended Tuesday. In the past two weeks, the total taken out of such funds totaled $75 billion. By contrast, institutional money funds that buy just U.S. government-backed securities had $27 billion in net deposits.”
The currency swap lines between the Fed and European central banks have in the meantime been quietly extended beyond their putative August deadline - a sign that the central banks are well aware that risks in this particular area of bank funding continue to persist.
In addition to the bank funding issue, the dollar has become a favorite funding currency for 'carry trades' – in the wider sense of the term. This is why there is a well-established negative correlation between the US dollar and so-called 'risk assets', including of course the foreign currencies that are the favorite target of the carry trade (in the more strict sense of the term, a 'carry trade' attempts to exploit an interest rate differential such as that between different currencies). There is no simple cause-effect vector at work, but rather a feedback loop. This is to say, not only can a sudden rise in the dollar lead to a liquidation of 'risk assets', but the opposite is just as likely –i.e., a fall in risk asset prices can cause a rise in the dollar, as dollars need to be bought to pay back loans that have been used to finance 'risk asset' positions.
It is important to keep in mind here that the fundamental backdrop for the US dollar remains to date quite bearish – not only is the Fed continuing its 'almost-ZIRP' policy of keeping the Fed Funds rate target between 0 and 0.25%, but growth in US money TMS has been quite brisk up until recently . While the most recent monthly annualized rate of growth of 'broad' TMS-2 has clocked in at a fairly slow (by recent standards) 3.6%, 'narrow' TMS-1 has grown at a hefty 18.4% annualized in May. The year-on-year growth in TMS-2 currently stands at 11.1%, while year-on-year growth in TMS-1 stands at 11.3%. The slowdown in the monthly annualized TMS-2 growth in May was largely due to a decline in savings deposits of 3.7% (also at a monthly annualized rate). By economic categorization, uncovered money substitutes at private banks fell by 10.5% annualized in the month of May – which buttresses our previously noted contention that following the end of 'QE2', the deflationary pull of private sector deleveraging could become an important factor slowing down US money supply growth (until the Helicopter pilot embarks on 'QE3', that is).
As it were, these data describe the past and not the future. They tell us that the effects of the Fed's monetary pumping are likely to continue to propagate through the economy and raise various prices, but they do not tell us anything about the extent of monetary inflation in the near future. In the absence of active pumping by the Fed, commercial banks must create more credit than is paid back, otherwise money supply growth could even turn negative for a while.
US money TMS-1, TMS-2, their yearly rate of growth, plus the growth in M2, and below Fed credit outstanding and its 12-month growth rate. As can be seen, there has been a close correlation between the expansion of Fed credit and the expansion in the money supply since the 2008 crisis. Unless the commercial banks increase their inflationary lending, money supply growth seems likely to stall out once 'QE2' ends.
We want to make two points here: there is on the one hand a purely technical reason that could lead to a dollar rally – namely the dollar funding needs of euro area banks and a possible liquidation of 'carry trades' (there are a number of potential triggers that could lead to carry trade liquidations, such as e.g. a worsening of the recent slowdown in economic activity in China and/or Australia, which may lead to a reassessment of commodity price trends and the exchange rate and interest rate backdrop of the Australian dollar, to name but two) and on the other hand there is a potential fundamental development, in the form of a potential slowdown in money supply growth following the end of 'QE2'.
As noted above, in order to gauge the likelihood of a rally in the dollar, we are also keeping an eye on certain technical signals. Take a look at the chart of the dollar index futures (DXY) below:
The US dollar index (DXY) – although it has recently put in a higher low, this is still a bearish looking chart at first glance. The best that can be said about it is that the downside momentum has slowed. However, take a look at the red line below the price chart. This shows the net positioning of large speculators in DXY futures. In spite of the fact that the dollar has not made any net progress over the past three months, these traders have begun to position themselves for a rise in the dollar.
