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Dollar Is Wandering Off Track

McClellan Financial Publications, Inc
Posted Jan 30, 2015

January 29, 2015

It is widely believed among economists and currency analysts that currency values follow the relative interest rates. We are told, “Money goes where it is treated best”, and so the currency which offers the best interest rate will attract the most capital.

But that does not really explain what has been happening over the past year. The US Federal Reserve has kept short term interest rates near zero, and just about every other central bank around the world has done the same. But the US Dollar Index is up 16% versus January 2014. So clearly the microscopic differences in interest rates do not explain this behavior.

If you were to look at a coincident chart of the Fed Funds rate versus the Dollar Index, it would be tough to prove that there is any real-time correlation at all. But people still think that such a correlation exists, and so they imprint their beliefs about what interest rates are going to do onto their expectation of what the currency will do. The expectation that the Fed will raise rates ahead of the European Central Bank (ECB) has pulled a lot more wealth into the dollar, boosting its value versus the euro.

But the belief that a relationship exists between interest rates and currencies is not completely wrong. The key to unlocking that relationship lies in seeing the lag time involved. This week’s chart helps to explain that relationship better. The plot of the effective Fed Funds rate is shifted forward by 3 years to reveal that the Dollar Index tends to follow in the same footsteps 3 years later. So yes, interest rates matter, but not for 3 years.

Interest rates are not the only factor which matters. Other topics will come along from time to time, and occupy investors’ attentions. This perhaps explains why we are seeing a rally in the Dollar Index now, even though the Fed Funds rate has been flat for several years. If one believes the legitimacy of this interest rate model, which has over 40 years of history to demonstrate its prowess, then there has to be something wrong right now. Either the Fed is stomping on the useful message from the bond market by engaging in price-fixing of the cost of money, or else the Dollar Index has no business being way up here.

My inclination is toward the latter hypothesis. The US economy is supposedly great, and worthy of a high currency valuation. But real employment numbers (not the massaged government ones) are not that great. And the falling oil prices will hurt the portion of US GDP related to oil production, whereas western Europe stands mostly to benefit from lower crude oil prices with no downside since the countries of western Europe hardly produce any oil. So this excursion off track by the US Dollar Index is likely going to have to get given back.

At the point when the Fed finally does start to raise rates, then we can start the 3-year clock for a real rise in the dollar.

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Jan 29, 2015
Tom McClellan
Editor, The McClellan Market Report
email: tom@mcoscillator.com
website: www.mcoscillator.com
(253) 581-4889

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