Why The US$ Is Rallying

October 7, 2014

As long as a market is in a strong rising trend almost any bullish argument could appear to have a ring of truth about it, even a completely baseless one. A case in point is the deluge of baseless, bullish-slanted US$ analyses prompted by the strong rise of the past few months in the Dollar Index.

Many of the fundamental reasons put forward for the US dollar's strength could seem valid at first glance simply because they match the price action, but many of these reasons are irrelevant or wrong. For example, considering its financial effect relative to the volumes of foreign exchange trading and international investment flows, there is no way that the US "shale revolution" and the associated move towards energy independence* could be a primary reason for a US$ bull market. For another example, the belief in some quarters that the US$ has been manipulated higher by the Fed is ridiculous, because the Fed wants a stable or a moderately weak dollar; it absolutely does not want a strong dollar. The reality is that speculators have ramped the US dollar's exchange rate upward contrary to the wishes and best efforts of the Fed. For a third example, the popular notion that the euro is being pushed downward against the US$ due to the potential for much greater monetary stimulus in the euro-zone is not just off the mark, it is diametrically opposite to what's actually going on. We'll now explain why.

To understand why the anticipation of greater monetary stimulus in the euro-zone could not have been the driving force behind the euro's recent sharp decline (and the resultant sharp rise in the Dollar Index**), the following points must first be understood:

1) As long as inflation expectations are low and stable, the stock market will usually be one of the earliest and greatest beneficiaries of monetary stimulus. Belief that the ECB was going to crank-up the money pumps would therefore almost certainly lead to substantial strength in European equities, especially with European equities not being particularly expensive. Furthermore, given that the Fed is known to be nearing the completion of its money-pumping, widespread anticipation of greater monetary accommodation from the ECB would almost certainly cause European equities to become strong relative to US equities.

2) The performance of European equities relative to US equities explains every important euro/US$ trend over the past 10 years. As evidence we have included, below, a chart comparing the VGK/SPX ratio (the blue line) with the euro (the green line). VGK is an ETF that provides broad exposure to European equities.

On a side note, we have previously used the STOX5E/SPX ratio as a measure of how European equities were performing relative to US equities, but this was a mistake because it involved putting a euro-denominated index up against a US$-denominated index. For such a ratio to be valid, both parts of the ratio must be denominated in the same currency. Otherwise, changes in currency exchange rate will distort the signal we are trying to obtain.

The point we've been working around to is that IF the financial markets really had been anticipating greater monetary stimulus from the ECB, then European equities would have been strengthening relative to US equities over the past few months and the euro would NOT have declined. Instead, European equities have fallen sharply relative to US equities over the past few months, pushing the euro downward. This means that rather than the main cause of the euro's recent weakness -- and the Dollar Index's associated recent strength -- being the fear that the ECB is going to stimulate (meaning: inflate the money supply) more aggressively, the main cause has been the fear that the ECB will be unable to stimulate aggressively enough.

In conclusion, we aren't arguing that the perceptions and realities of the ECB's performance are the only causes of the euro's plunge and the related rally in the Dollar Index. There have been other contributing factors, one being the US-initiated economic sanctions against Russia that the EU stupidly went along with. These sanctions have prompted Russia's government and private sector to establish closer trade ties with South America and China, which means that the sanctions could lead to the permanent loss of business for some EU industries. We are, however, arguing that the perceptions and realities of the ECB's performance are by far the most important causes. In particular, from mid-2012 through to mid-2014 the markets were comfortable that the ECB would make good on Mario Draghi's promise to "do whatever it takes", but about three months ago the markets started to doubt the ECB's ability to follow through. The ECB is now being asked to deliver more than words, and the response, to date, has been two programs that aren't expected to provide the desired inflationary impetus.

    *Note that energy independence is not, in and of itself, a worthwhile goal. It is also not necessarily an economic plus. It only makes sense to produce energy locally, rather than import it, if the risk-adjusted cost of local production is lower than the risk-adjusted cost of importation.

    **The USD/EUR exchange rate is about 60% of the Dollar Index, so the Dollar Index almost

always trends in the opposite direction to the euro.


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