The Dollar Rally
Many economists are saying that the fundamentals for the dollar are improving and that it is only natural for the dollar to strengthen: with the U.S. economy "clearly" strong and U.S. interest higher, capital is once again flowing into the U.S. I would agree that capital flows are positive and that interest rates are higher, but the why of it all is very different in my mind.
The dollar's quick rise is telling of a short squeeze. As interest rates have risen and the yield curve shifted, capital is indeed flowing back into the U.S. not because of new capital seeking the best return for the risk, but rather because the "carry' trade is being unwound.
If a broker dealer has been borrowing short term in the U.S. to finance longer term German bonds, they have been making a good spread because short term rates in the U.S. have been artificially low relative to longer term European rates. Now that short term borrowing costs in the U.S. are rising, the broker dealer must unwind that trade as spreads come in. The unwind entails selling German bonds and paying down the short term borrowing facility. This entails buying dollars.
This seems to be going on in good size and has nothing to do with fundamentals. Traders are not concerned that the trade deficit is widening, a function of a strong dollar, they are only concerned with their profits and losses. It is a very powerful motivation.
When this technical situation stops no one knows, but when it does the dollar is likely to once again reflect very poor fundamentals for the dollar: very low (even non-existent) U.S. savings rates and consequently mind numbing foreign borrowing.
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