It’s not the news that’s key, but the reaction to the news that counts. On Wednesday, currency markets saw a quick 1% decline in the dollar index and its corresponding ETF, the Powershares DB US Dollar Index Bullish (UUP, Financial), in less than two hours. This is unusual movement for any currency, let alone the world’s reserve currency.
It gets more interesting, though. The quick dollar dump happened at around the same time that the Federal Reserve announced some loose timing for its much-anticipated paring down of its $4.4 trillion balance sheet. Due to a change in wording from “this year” to “relatively soon,” in the most recent Federal Open Market Committee statement, it is now believed that the Fed is looking to start paring its balance sheet at $10 billion a month in September.
The dollar and Treasury markets then proceeded to react in the opposite way as would be expected on such an announcement. It is, after all, the beginning of the liquidation of the most gargantuan central bank balance sheet in U.S. history.
One would expect the dollar to rise and bonds to fall on such news. If the Fed is going to liquidate some of its balance sheet consisting mainly of U.S. Treasurys, that means it is not going to be buying any more Treasurys, as it will not be reinvesting proceeds. So why would Treasurys rise on such news of losing such a big buyer? Further, the dollars accumulated by collecting the yields with reinvesting into more Treasurys means the money will be retired and taken out of the money supply, lowering the amount of circulating dollars in the economy than otherwise. If the supply of dollars is about get lower on the paring of the Fed’s balance sheet than otherwise, why would the dollar tank 1% on the news?
What may have happened here is that dollar sellers were looking to sell into strength and took the Fed’s wording as a sign to sell. Buyers, however, did not put in higher bids to compensate. If true, that means that forex traders are looking to get out of the dollar, and few are looking to get back in even on the back of bullish dollar news.
This may be partly due to a dangerously bearish technical chart pattern with the dollar index right near three-year support levels at 92, last hit in May 2016. If that support breaks, the next support level is at 83, about a 10% drop from where we are now in the dollar index.
With the Fed on a clear rate hike path and no more Fed bond buying on the horizon, such a bearish chart pattern in the dollar should not be happening. And yet it is. The situation seems to betray Wall Street’s true sentiment on the U.S. dollar, which does not seem too positive right now.
Which raises the question, what happens when a piece of bearish news hits the dollar? There could be many of these in the coming months. Sanctions against Russia, currently being debated in Congress with the tacit approval of the Trump administration, is one possibility. The European Union has indicated it may retaliate against the U.S. if such sanctions are enacted. Combine that with news of any additional new tariffs from a protectionist administration and the dollar could really slide down to support pretty quickly.
Another possibility is the Fed backing away from an any expected rate hike, or backing away from its stated intentions of actually paring down its balance sheet. If the Fed reneges on these expected moves, the dollar could suffer badly. Losing its late 2014/early 2015 gains in a waterfall decline is not out of the realm of possibility.
