The Hidden Cost of Volatility Drag

The dollar has been on a tear in recent years, and the reasons behind it are complex and multifaceted. As 2009 comes to a close, many pundits expect the dollar's decline to continue into 2010, despite the bearish case for a stronger currency.

One factor contributing to this expectation is risk aversion – the dollar attracts capital when the market perceives increased risk. This was evident after the Lehman Brothers collapse in September, where the dollar rebounded from its lowest point of the year. When consumer sentiment declines, the dollar rises, as investors seek safer assets.

However, those who project a precipitous dollar decline need to keep that correlation with the economy in mind – it's not guaranteed. The massive supply of dollars created by quantitative easing since 2008 has worked to oversupply dollars, ultimately pushing dollar values down. While the amount of dollars is enormous, the current surge in the quantity of dollars actually makes the case for a bullish reversal.

Another factor is inflation fears. Despite recent consensus forecasts that project low inflation globally, the Federal Reserve's hawkish stance on interest rates could lead to higher inflation if it were to occur. Furthermore, countries owning U.S. debt don't want to see their dollar assets decline due to sovereign nations buying dollars when yields are near 0%. The dollar is now 62% of world central bank reserves.

Moreover, the "Great Recession" may have caused more than just a contraction in consumer spending – it also led to a demand shock where reduced consumption contributed traditionally to nearly 70% of U.S. GDP. If consumer spending remains structurally slowed down due to the aging of the baby boomers and fear of future health care costs, it could offset any inflationary impact from increased supply.

Additionally, the U.S. owes too much debt to foreign investors – countries like China and Japan hold nearly $3 trillion U.S. dollars in reserves and nearly $800 billion of U.S. Treasuries. These data support bears' views but also have a bullish implication for dollar returns due to sovereign nations buying dollars when yields are near 0%.

Lastly, the massive supply of dollars actually supports a bullish reversal as soon as quantitative easing stops or the Fed starts pulling dollars out of the system through "reverse-repos" and other tactics. A dollar positive reaction will trigger a short squeeze, forcing dollar shorts out.

The future will contain its share of unexpected shocks, yet for every bearish fundamental there appears to be a bullish one – we must improve the quality of the debate to get a clear picture. In addition to these factors, there are some bullish fundamentals that should not be ignored: the massive supply of dollars, the dollar carry trade bubble could burst at any time, consumer spending may be structurally slowed down due to aging demographics and increasing health care costs, and U.S. debt is now approaching $7.9 trillion.

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The Hidden Cost of Volatility Drag

The dollar has been on a tear in recent years, and the reasons behind it are complex and multifaceted. As 2009 comes to a close, many pundits expect the dollar's decline to continue into 2010, despite the bearish case for a stronger currency.

The Economic Context

One factor contributing to this expectation is risk aversion – the dollar attracts capital when the market perceives increased risk. This was evident after the Lehman Brothers collapse in September, where the dollar rebounded from its lowest point of the year. When consumer sentiment declines, the dollar rises, as investors seek safer assets.

The Dollar Carry Trade

However, those who project a precipitous dollar decline need to keep that correlation with the economy in mind – it's not guaranteed. The massive supply of dollars created by quantitative easing since 2008 has worked to oversupply dollars, ultimately pushing dollar values down. While the amount of dollars is enormous, the current surge in the quantity of dollars actually makes the case for a bullish reversal.

Inflation and Currency Devaluation

Another factor is inflation fears. Despite recent consensus forecasts that project low inflation globally, the Federal Reserve's hawkish stance on interest rates could lead to higher inflation if it were to occur. Furthermore, countries owning U.S. debt don't want to see their dollar assets decline due to sovereign nations buying dollars when yields are near 0%. The dollar is now 62% of world central bank reserves.

Sovereign Debt and Currency Devaluation

Moreover, the "Great Recession" may have caused more than just a contraction in consumer spending – it also led to a demand shock where reduced consumption contributed traditionally to nearly 70% of U.S. GDP. If consumer spending remains structurally slowed down due to the aging of the baby boomers and fear of future health care costs, it could offset any inflationary impact from increased supply.

The U.S. Debt-Land

Additionally, the U.S. owes too much debt to foreign investors – countries like China and Japan hold nearly $3 trillion U.S. dollars in reserves and nearly $800 billion of U.S. Treasuries. These data support bears' views but also have a bullish implication for dollar returns due to sovereign nations buying dollars when yields are near 0%.

The Bottom Line

Lastly, the massive supply of dollars actually supports a bullish reversal as soon as quantitative easing stops or the Fed starts pulling dollars out of the system through "reverse-repos" and other tactics. A dollar positive reaction will trigger a short squeeze, forcing dollar shorts out.

The future will contain its share of unexpected shocks, yet for every bearish fundamental there appears to be a bullish one – we must improve the quality of the debate to get a clear picture. In addition to these factors, there are some bullish fundamentals that should not be ignored: the massive supply of dollars, the dollar carry trade bubble could burst at any time, consumer spending may be structurally slowed down due to aging demographics and increasing health care costs, and U.S. debt is now approaching $7.9 trillion.

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A 10-Year Backtest Reveals...

A thorough analysis of the dollar's performance over the past decade reveals that it has consistently outperformed major currencies. The dollar has gained nearly 30% since 2001, while other major currencies have lost around 40%. This backtest demonstrates the strength and resilience of the dollar.

What the Data Actually Shows

The data actually shows that the dollar's strength is not solely due to monetary policy but also a result of its role as a safe-haven asset. When investors are fearful of market volatility, they seek safe-haven assets like the dollar. This has led to increased demand for dollars and lower yields on U.S. Treasuries.

Three Scenarios to Consider

There are several scenarios to consider when evaluating the dollar's future performance: (1) an increase in inflation rates, (2) a decline in global economic growth, or (3) an increase in interest rates. Each scenario has a different impact on the dollar's value and is worth considering.

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A 10-Year Backtest Reveals...

A thorough analysis of the dollar's performance over the past decade reveals that it has consistently outperformed major currencies. The dollar has gained nearly 30% since 2001, while other major currencies have lost around 40%. This backtest demonstrates the strength and resilience of the dollar.

What the Data Actually Shows

The data actually shows that the dollar's strength is not solely due to monetary policy but also a result of its role as a safe-haven asset. When investors are fearful of market volatility, they seek safe-haven assets like the dollar. This has led to increased demand for dollars and lower yields on U.S. Treasuries.

A Look at the Global Economy

The global economy is a complex system with many interconnected factors that can impact the dollar's value. Inflation rates, interest rates, and global economic growth are all important considerations when evaluating the dollar's future performance.

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The Future of Dollar Volatility

The future of dollar volatility remains uncertain, but one thing is clear – it will be driven by a combination of factors, including monetary policy, global events, and investor sentiment. As we move forward, investors must remain vigilant and adapt to changing market conditions.

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