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Why is the Dollar Falling?
When the U.S. financial sector seemed to be on the verge of collapse, the U.S. Dollar was strengthening. Now that a plan for a massive bailout of financial companies has been announced, and financial Armageddon appears to have been averted for the time being, the U.S. Dollar is falling. Shouldn't this be the other way around? Why would the USD seemingly rise on bad news and then fall back on good news? On the surface this would seem to be a contradiction, but actually there is a method to the madness. Looking at the daily chart of the US Dollar Index, which measures the greenback's performance against a basket of currencies, it's apparent that the USD rally has hit a bump in the road. As of now, the index is testing the 50% Fibonacci retracement of the rally that began back in July (see figure 1).
Figure 1: Recent rally in the USD Index has pulled back by 50%. Source: Saxo Bank
To understand why this is happening, consider this – when Freddy, Fannie, AIG, and Lehman were going down the tubes, fear gripped the markets. There are a variety of places that a trader can stash his cash when the stock market becomes too risky, and one of those places is in bills, notes, and bonds issued by the U.S. Treasury. U.S. Treasuries are highly liquid, so a hedge fund can park many millions of dollars there with no trouble, and remove that money and put it back into the markets anytime he or she pleases.
So imagine that a global hedge fund, with investments all over the world, decides to sell its European stocks because the market is too risky. When the sale is made, the fund manager receives Euros in return for those stocks. Perhaps the manager would like to put that money into U.S.
Treasuries, but what must happen first? He or she must exchange Euros for U.S. Dollars – essentially selling the Euro and buying the USD – to obtain U.S. dollars in order to purchase the Treasuries. This would be no big deal if a few banks or hedge funds were doing this, but what if the fear is so pervasive that many of them start doing it at the same time? This massive buying of the USD in order to purchase Treasuries was a big factor in the recent USD rally.
So now that the plan to bail out the banking system is taking shape, fear is subsiding and traders are pulling money out of US Treasuries, possibly to put that capital to work in world equity markets. They may be converting USD to the Euros, British Pounds, and other currencies in for use in various investments, resulting in a flow of capital out of the U.S.
That explains the short term movement in the USD, but what are the long-term prospects? While there are various estimates as to the size of the bailout, with most analysts currently placing the bill at around one trillion USD, the truth is that nobody knows how much this will cost in the long run. It's likely that the US will pay the freight through massive borrowing, which will weigh heavily on the nation's balance sheet and thus cause further harm to the U.S. Dollar. Additionally, this plan essentially rewards the bad judgment and excessive risk taking that created this mess in the first place.
But if you really want to know what the market thinks of this bailout plan, just take a look at the price of oil. Yesterday, September 22, 2008, crude oil prices shot into the stratosphere, at one point rising by more than $25 USD per barrel before pulling back, its biggest one-day increase ever. The leap in oil prices is telling us that the market believes the greenback will suffer greatly due to this bailout, so we will need more dollars to purchase a barrel of oil – and everything else that is imported into the US – in the near future. It is a sad commentary indeed (see figure 2).
Figure 2: Crude oil rockets higher on USD weakness. Source: Saxo Bank
New Rules for Short Selling
In the U.K, the FSA (Financial Services Authority) announced last week that short selling of financial stocks would no longer be tolerated. The next morning, the U.S. announced a similar temporary rule against shorting companies in that troubled sector. While there have been abuses and possible manipulation in the form of so-called "naked" short selling – due to lax enforcement of rules that are already on the books – it is not the fault of traders, be they long or short, that many financial institutions decided to load up on subprime toxic waste. The press over here has been particularly brutal, slamming short sellers on the front pages of the daily newspapers as greedy vultures. In an attempt to create a villain and whip the public into frenzy (a great way to sell newspapers), they are suggesting that financial stocks are falling due to some evil conspiracy, as opposed to bad decision making and poor risk management. Anyone who manipulates stocks should be punished, but let's not brand all speculators and short sellers as manipulators.
But the ban on shorting could backfire; without short sellers, investors will have a harder time gauging the true value of a stock. Ultimately, the ban on short selling could actually distort prices, creating unrealistic valuations. Shorts keep the market honest by punishing bad companies, and if we lose the ability to do that, can we really trust the valuations these companies receive?
In the final analysis, a trading market is either a free market, or it isn't. While the equity markets drift farther away from free market principles, the major pairs in the currency markets remain relatively devoid of these types of obstacles. In other words, I may not be able to short U.K financial stocks, but at least I can short the British Pound. Keep that in mind when you ask yourself, "am I trading in a free market?"
Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.
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Ed Ponsi is a globally recognized name as a lecturer and teacher and is the former Chief Trading Instructor for Forex Capital Markets. An experienced professional trader and money manager, Ed has advised hedge funds, institutional traders, and individuals of all levels of skill and experience. Ed has appeared on CNBC, CNN International and TheStreet.com, and has recently written his first book for Wiley Finance, "Forex Patterns and Probabilities" (which you can purchase through