Dollar Fundamentals - Is the recent trend real or false?

A question of vital importance is whether the recent dollar rally is real or fake. If fake, it is an engineered outcome of central bank policy (US, EU and JP combined) and it will fail, possibly spectacularly.

If real, it could portend a major trend shift with powerful implications for commodities, interest rates, and the stock market. At the highest level, like any commodity, money will rise in the international markets when there are more buyers than sellers. It will fall when there are more sellers than buyers.

Here are the legitimate (non-intervention) reasons that there would be more buyers:

  • US dollars are needed to pay off or settle debts denominated in US dollars. Suppose that foreign banks had large positions in US interest rate swaps (a derivative), which they were only holding in their trading accounts as a notional value, and suddenly had to settle up in dollars. This would create demand for dollars.
  • The Yen “carry trade” was still growing. In this scheme a hedge fund (for example) would borrow Yen at a low interest rate, sell those Yen into the global market, and buy dollars, which are then invested in higher-yielding US treasuries. This creates demand for dollars.

Here are the reasons that there would be more sellers:

  • Trade deficit remains high. The trade deficit means that US consumers and businesses are importing more than they’re exporting. When this happens, dollars flow out of our borders to foreign manufacturers, which have to convert the dollars into their local currency. Dollars get sold to accomplish this.
    • These dollars are then absorbed by the local central bank, which then decides whether to hold them or sell them. One way of holding them is to hand them back to the US, where they are held in a special “custody account” at the Fed. Over the past year, this account is up a whopping $414 billion. Over the past week, it has actually fallen, indicating that perhaps the dollar’s mysterious climb is about over. (
  • The US budget deficit remains high. With a big, sustained fiscal deficit, the US government is, in effect, creating more spending than economic growth. A large fiscal deficit implies that inflation is coming, and, all things being equal, it should create less of an appetite for US dollars. Since the US dollar is the reserve currency, this dynamic is muted (at present), but it is certainly a factor for all other countries and should (will) play a role here as well.
  • The US interest rate remains below that of other countries. This is most assuredly the case, where the US is a full 2% or more below the rate offered by other industrialized (and safe) countries.
So here’s a graph of the dollar's surprisingly strong advance. See how many “fundamental factors” you can find that would explain its rise. It also bears noting, in addition to the data points marked, that the US economy deteriorated over this span (as measured by employment, consumer confidence, industrial output, and consumer spending) and that the Fed held interest rates at a measly 2% in August.


Data Point #1

U.S. federal deficit balloons to $268.7B
WASHINGTON – The U.S. Treasury Department says the country's federal deficit swelled to $268.7 billion in the first nine months of this budget year [October to June] as record spending during the period outpaced revenues.

Link to article


Data Point #2

Federal Budget Deficit Hits $102B In July

WASHINGTON (AP) ― The federal budget deficit soared in July, pushed higher by economic stimulus payments and $15 billion in outlays to protect depositors at failed banks.

The Treasury Department reported that the deficit for July totaled $102.8 billion, nearly triple the $36.4 billion deficit recorded in July 2007.

Link to article


Data Point #3

Dollar rises as yen slides on Government take-over of Freddie, Fannie

LONDON (Reuters) - The dollar jumped against a broadly weaker yen and rebounded against a host of currencies on Monday after the U.S. government took control of Fannie and Freddie Mac

Link to article


Data Point #4

Federal Shortfall To Double This Year

A weak economy and a sharp increase in government spending will drive the federal budget deficit to a near-record $407 billion when the budget year ends later this month, and the next president is likely to face a shortfall in January of well over $500 billion, congressional budget analysts said yesterday

Link to article


Data Point #5

US July trade deficit widens to $62.2 bln vs $58.0 bln expected

WASHINGTON (Thomson Financial) - Record high US petroleum imports and record high prices for an imported barrel of oil led the US trade deficit to widen more than expected in July to its highest level since March 2007, the Commerce Department reported Thursday. Commerce reported a $62.2 bln deficit in July, up 5.7% from the revised $58.8 bln trade gap in June.

Link to article


Back to my original question. Overall, I am going to have to answer "fake" for this dollar rally, at least on the basis of observable fundamentals. Of course, I have no hard data around the potential need for dollars as derivative bets get unwound, so this could be in error.



This is a companion discussion topic for the original entry at

I’m not sure you can really tell anything from this – its such a short-term thing. I do think that economic actors tend to park their assets in U.S. Treasuries in times of uncertainty (look at what happened with them today), but its more a reflexive “getting out of something else”, as opposed to an affirmative move towards the dollar. I really think that’s what’s going on here. So its real to the extent that people would prefer dollars over, say, shares of WaMu or AIG. But that doesn’t mean they will keep the dollars long-term.
Also, bear in mind that lots of activity involving dollars happens for non-economic reasons. Check out China’s recent investment activity in Costa Rica, which was supposed to be kept secret:
Global politics makes strange bedfellows indeed.

I keep a mental picture of the central banks as a team of sky divers who can’t control their rate of descent in their frustrated attempts to make formation. When it came time to open their parachutes, they found to their dismay that they don’t work. Some keen observers have made a strong case for deflation due to the strength of the housing credit collapse. That argues for a stronger dollar until the forces of deflation are overtaken by the forces of inflation. When? When foreign debt holders will not be able to absorb the Federales exploding debt load. That would leave them with the remaining options of trying to spend and inflate their way out. They cannot possibly save the dollar.

Hi Chris, Thanks so much for answering my questions on the US dollar. Just a few follow up questions… if the Fed cuts rates again, won’t this make the carry trade that less desireable and given the global loss in wealth due to falling markets everywhere, the Carry trade will have to compete with the opportunity costs of other investments. Does the return on capital work for the carry trade anymore? Also you referred to a possible paradigm shift in how the US dollar trades to commodities and the implications for the whole market. Could you expand on that a bit more?

hi chris thanks for the chart and the explanations. mr. bush has for years said the fundamentals are strong and now i heard hank on the radio today say the fundamentals are strong. even the homeless guy i gave some food to today said the fundamentals are strong. i also read today that the fed may lower interest rates at the next meeting. so if employment is a fundamental and the budget deficit is a fundamental and if consumer confidence is down and consumer spending is down and industrial output is down (all fundamentals) oh yes and inflation is up to what? 5% or is it 13%? and the government is bailing out everyone who needs a quick 100 billion, and investment banks are dropping like flies. oh yes and i remember the old saying " as GM goes so goes the nation" am i missing some fundamentals here or am i being lied to? perish the thought.

I’ve worked with the various Ratings Agencies for years and let me tell your readers something… they’re no better or smarter than any other portolio manager out there. We have begun to depend on them out of laziness and the whole system has become dependent on them like what they say is the word of God. If the ratings agencies weren’t around, it’s not like derivatives or financial structures wouldn’t exist, it would just put the onus onto the buyer/seller to do their OWN due diligence. To have contracts become null and void due to a ratings cut is ridiculous and has put the whole financial system on a very thin sheet of ice. Too many have become complacent and created a market for the ratings agencies despite the inherent conflict of interest. Much of what is happening today has to do with the ratings agencies in my opinion. MBI told the ratings agencies to go screw off and I thought that was brilliant. I guess it’s too late now but it’s something the pundits should look at ie. getting rid of the ratings agencies.

While I agree that the Fed most certainly has attempted to manipulate the value of the dollar. I really think giving the Fed credit for this is thinking too highly of them. To say a bunch of incompetent fools who couldn’t even find their own rear end could pull something like this off. Ha!

Instead, I fear this comes down to something sadder, and all the more gut wrenchingly terrible. Deep down in their hearts, Americans just don’t believe in long recessions. No really, gander at this list of recessions in the Wikipedia. Notice how short most recent recessions are (and how long many older ones were)? Now, put it in context. Its already been over a year, things have been rather ‘mild’ for all the ‘talk’… at least to those people not directly effected (90+% of us).

It would be easy, wouldn’t it, to belive things are about to come to an end. Now imagine a whole nation subtly angling itself to take advantage of the post recession bull…, all the while internally snickering at ‘poor socialist Europe’, which is facing a real recession.

It suddenly makes a horrible sort of sense, doesn’t it? Simply put, most Americans truly believe(d) that it was all over, or so close it didn’t matter. The next few weeks however, are likely to be a nasty reality check.


I expect the USD has just completed a normal and expected corrective cycle - the data and patterns say is not a new bull trend for USD, weakness is expected to return and may have already begun last Thursday, Sept 11.
As a forex trader USD strength/weakness and trends are the key aspects that must be decided whenever I create a trade plan. My Elliott wave analysis tells me the USD has been losing value since 2001 within a down sloping channel, that is not yet complete, it has one more low to reach. The past 6 months have been a bear market rally for USD Index, which means it is a wave 4 counter-trend rally in a typical 3-wave pattern that may have completed on Sept 11th. A Correction is essential before the final 5th large wave down that will take 3-6 months to play out.
I cannot guarantee that USD Index will fall now, although conditions are ripe for a swing in the cycle back to the larger down trend. There are alternate wave counts that have not been ruled out at this stage, that consider a deflationary interpretation where USD gains strength for a few more weeks. USD weakness is the preferred count and larger established trend, if the correction is indeed finished as the chart evidence shows.
I can say that conventional linear thinking does not work in forex. Analysts cannot look at a cause = effect to determine trends or price movements with any more than 50% accuracy. In other words, fundamentals and new events do not determine markets, and are no better than tossing a coin, although it is the predominate (95%) method used by forex traders. Elliott wave patterns are the most accurate way to determine the trend and targets for a movement, because it is based on cycles of human optimism to pessimism that govern socioeconomic markets.
Expect the best - Prepare for the worst.

Chris, You have been suggesting that the dollar rally over recent months has been the product of concerted action. The price of gold has defied expectation over recent weeks, moving lower when events would suggest it should move higher. Today we see a remarkable run up in gold all at once. Does this suggest that the artificial propping up of the dollar may be at or near the end? Does it suggest that what amounts to an artificial suppression on the gold price may be at or near the end? Thanks!