Carrying the Dollar

So I blogged about my thoughts on the future of the US Dollar a while back.

Three months later, the USD continues its unstoppable decline, showing no signs of stopping. Recently, I’ve observed that the dollar no longer jumps drastically when markets become jittery (and investors pile into safe haven assets) – indicating that the dollar is slowly but surely losing its status as the world’s reserve currency. I think, because of a lack of a good current alternative, that the Yen is now the currency of choice for most people.

The reason for the dollar’s demise? The Fed’s decision to firmly hold on to near-zero interest rates, making the dollar an attractive borrowing asset for a no-brainer carry trade.

A little background: A carry trade is a strategy which involves borrowing an asset with low interest rates and buying an asset with higher yielding rates. If the exchange rate remains unchanged, you earn the interest rate differential in a near-arbitrage. Furthermore, as this is a well known trade, many people do this as well and push up the prices of the high yielding asset – allowing you to profit from being long that asset as well. (Okay, maybe not ALL my finance classes are completely useless).

This is essentially what’s happening in the world: People are borrowing in dollars and using it to purchase commodities such as gold and oil. These assets, priced in dollars, have been trending upward for months – the same time that the dollar has been falling. You can profit from an increase in value, and assets like gold are essentially a hedge against inflation and a falling dollar.

So what’s the conclusion? That the dollar will fall and lose its status as the world’s reserve currency, that inflation will spiral out of control and assets will hit the roof?

It’s not so simple: The Fed is watching inflation like a hawk. The combination of low interest rates, quantitative easing and free liquidity flowing through the world today will most certainly lead to inflation. And when that happens, the Fed will raise rates, possibly in a drastic way. We will then see a possibly sharp reversal of the dollar/commodities carry trade, with the dollar spiking and Treasury/commodity prices falling – nay, crashing – similar to the dollar/yen carry trade of 1998.

I’m not sure when this will happen, but I’m pretty sure that it will. We’ll see where that takes us.

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One response to “Carrying the Dollar

  1. I think the FED will not raise rates so easily as they still have this big deficit to finance. They will hold rates low until they have no choice—when inflation threatens to get out of hand.

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