Why the US dollar Moving higher is bad news – Forex Trading For Beginners

In this series of analysis, I want to put together a Forex Trading For Beginners look at what is going on with the US dollar and why the recent moves matter to all of us.  For those that follow along, there may be significant ramifications to the recent surge in the USD.  Most of my followers are more focused on cannabis stocks.  However, only looking at individual stocks without taking in to consideration the economy that these companies exist would be dangerous at best.

For those that are not aware, my DNA is in Forex trading.  I managed a hedge fund and conducted the trades on this fund.  My focus was entirely on economics & applying economics to the Forex market.  I traded options almost solely as my weapon of choice.  Although I no longer actively trade forex, I still follow forex moves all of the time.  The recent moves in the forex market were extraordinary.  And, I wanted to point these out because they will have seismic changes to the world economies.

These moves we just saw are the beginning of bigger ripple effects we will see throughout the financial world.  And, they affect the US economy as well as individual stock holdings.

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What moved the USD

When it comes to forex moves, if there is one thing that you need to keep in mind it is that everything is relative.  Here is the latest USD Index move:

Dollar Index 30Sep22

So, what moved the USD Index?  It all started with the upward moves in interest rates.  Remember, and I will say it a million times, everything is relative.  This shift upward in the latest move – post COVID – was the move in June of 2021.  This was the beginning of this far larger move.  That began with a move upward with interest rates here in the US:

US 2-Year Treasury Yield

At the very bottom of this move after all countries locked down due to COVID, a little past the 1-year mark, US Treasury yields started to move back upward.  This shift upward started to attract money from around the world.  If you have 10-year interest rates in Japan yielding only 0%, and all of a sudden the yield on US Treasuries starts to increase significantly, this will attract more and more investors into wanting to capture that yield increase.

Yield Differentials

Here is the same chart of the 2-year yield on US Treasury bonds versus the 2-Year yield on Japanese bonds:

US 2-Year yield versus Japanese Bonds 2-Year yield

In the chart, toward the far left, you can see the beginning of the move upward in yields for the US Treasuries.  During this same period of time, Japanese yields have remained negative.  Investors in Japan, wanting to capture that yield differential would be moving money out of Japan and into the US to invest.

But, it is not necessarily just Japanese pensioners who would be doing this.  The forex market pays investors every night for owning one currency versus owning another currency.  A position in the forex market is derived from the actual currency exchange but represents a derivative that is a position that is borrowed against.

These positions are called the Carry Trade. They occur because a position is carried from one day to the next.  And, since they are borrowed positions, the individual that is long the lower amount pays the individual that is long the higher amount the differential between the two currencies.  This differential attracts more and more investors and has a feedback mechanism.

As Japanese Government Bonds have yielded negative rates, and the US Treasury has yielded more and more interest, the carry trade is profitable and pushes itself more and more.

Bank of Japan Intervenes

The most recent move of currency flow was so dramatic that it triggered wide-spread selling of JPY versus its partnering trade currencies that the Bank of Japan was forced to step in and manipulate the currency in order to stave off chaotic moves.[1]Bank of Japan Intervenes. The BoJ expended a record $20B to maintain order in the currency markets.

It is not that the Bank of Japan wanted to support the currency as much as it wanted to maintain orderly flow.  The moves last week were beyond orderly prompting the BoJ to step in.


US 2-Year Yield versus GB 2-Year Yield

The same goes for all government bonds around the world.  The British Pound sold off sharply on a combination of poor fiscal management by the new Prime Minister and its government.  As the above chart shows, and unlike the Japanese government bonds, interest rates in England are far similar to that of the United States.

However, the recent fiscal fiasco has led to massive selling in the British bond markets.  This selling has pushed the bond rate upward and, similar to the Bank of Japan, the Bank of England stepped in to intervene and ensure orderly flow.[2]Bank of England to Step In And Buy Bonds

The end result was the swift drop in the GBP versus USD:

GBPUSD 30Sep22

How this affect the US Investment Environment

Given the massive flows that are occurring, with investors shying away from Japan, Great Britain, and the EuroArea, how does this affect investments in the United States?

The answer to this lay in the Federal Reserve Balance sheet:[3]Trading Economics Federal Reserve Balance Sheet

Federal Reserve Balance Sheet

The Federal Reserve has been actively cutting its balance sheet in order to contain inflation.  The balance sheet is one of the key factors the Fed has used to create liquidity in the US economy after the COVID lockdowns.  The Fed is cutting back $95B monthly.  But, while the Fed is slashing its balance sheet, the factors of more money flowing in to the United States via the carry trade will affect the liquidity in the US.

The US dollar soaring like it is will first create losses on a currency basis for multinational companies and this will rock the stock market, which we have clearly seen lately.  As the USD has soared on inflation and its promise of higher interest rates, the stock market has simultaneously dropped:

S&P 500 Monthly

And, as more money comes in, the pressure on the USD will force the Fed to continue removing liquidity while simultaneously forcing the hand of the hand of the Federal Reserve to continue raising interest rates.  The negative feedback loop on this will be an economy that contracts even further than originally imagined.

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