Reasons For US Dollar Strength

Some people may be wondering why the dollar has strengthened so much lately as the Fed has been flooding the system with dollars. Here is a quick list of possible explanations:

1) Margin Calls

U.S. markets are definitely the most liquid for commodity, currency and index futures. As these sharp moves occur, traders all over the world are forced to post additional margin. The problem is that they largely don’t hold USD in cash. In fact, the global foreign exchange imbalances were so bad prior to the crisis that most people refused to hold USD - even U.S. based traders. All of a sudden you get margin calls and are forced to post either USD or treasuries. This caused a stampede into dollars

2) Hedge Fund & Mutual Fund Redemptions

As the global economic boom story took hold, U.S investors increasingly invested abroad. Calls from top investors to buy non-USD denominated assets hit the investing public and money rushed into global plays. As the story unfolded, money was repatriated and redemption’s caused the sale of equities and the purchase of dollars. These dollars largely found their way to treasuries.

3) The Purchase of Treasuries

As money runs to safety seeking any yield, as small as it may be, treasuries have been bid up like stocks in the dot com bubble. People don’t care how much they pay for them any more. The consequence of this is that there are fortunes of treasuries in the market right now and the USD has in effect been taken out of circulation as it is sitting with the treasury. Then when banks in Asia or Europe need dollars for regular operating purposes (to buy commodities for example), there are none left to borrow. Everyone they ask have treasuries but no actual dollars. This forces the bid up on the dollar and adds more to its strength.

Looking Forward

We are now in a US dollar/treasuries bubble, but when that will burst is anyone’s guess. I expect that when the bubble bursts, money will run out of treasuries and likely out of dollars as well. However that is not certain. What is highly likely is that several years from now, people won’t be willing to lend money to the treasury for next to no yield.

For fun I have to mention the extreme negative USD sentiment that existed prior to the crisis. Remember when the highest paid model in the world, Gisele Bündchen, stopped taking payment in USD? The EUR/USD was at 1.50 at the time. That should have been a great contrarian signal!

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