The Dollar's 'Illogical' Move is Actually Logical, Which Makes the Next Move Predictable

The Euro/Dollar (EUR/USD) is at its lowest level for months (a lower EUR/USD means a weaker Euro and therefore a stronger Dollar). There is nothing too remarkable about the move down; it hasn’t been particularly steep or spectacular in terms of the often-volatile forex market. We have returned to the low of a few weeks ago and so far, haven’t broken through it. Still, the drop over the last two months has been spectacular, and what's fascinating is that it's happening when it is. Now is a time when basic market theory seems to suggest the dollar should be sliding; after all, inflation is becoming a problem in the U.S.

PPI, RPI, retail sales, consumer durables, even Friday’s jobs report: you name it, the figures are showing inflationary pressure on every front. That should logically mean a lower dollar. We tend to think of inflation as rising prices, but if you think about it, it could just as well be expressed as a falling dollar relative to everything else. If an apple costs one dollar before inflation, and then two dollars after it, the “price” of the apple has increased, but the buying power of the dollar has decreased. The same dollar bill that was worth one apple before is now worth half an apple.

So, if inflation is coming, or already here, why is the dollar gaining ground? As is always true in markets, even this illogical-seeming move is actually quite logical if you dig a little deeper.

Forex, like all markets, is both comparative and forward looking by nature. On the comparative front, yes, America is staring inflation in the eye, but so is everyone else. The question then becomes how, and more importantly when, the Fed will respond to that pressure relative to other monetary authorities around the world. This move tells us that the market expects the Fed to fold quite soon and signal earlier a forecast rate hike.

They may be forced to do just that, because even as inflation takes hold, Congress is still trying to deficit spend their way out of last year’s recession. The infrastructure bill is needed, for sure, and one can even make a strong and convincing case for the “human infrastructure” bill that will follow it, but the spending is still inflationary, no matter how well intentioned or needed. That is especially so because there is absolutely no chance of any significant tax increases to pay for it. Given the Republicans’ love affair with Grover Norquist and the Democrats’ determination to live down their deserved reputation as a “tax and spend” party, creating a coalition of politicians prepared to vote for tax hikes is virtually impossible these days, hence the national debt of $28.62 trillion and growing.

That puts added pressure on Jay Powell and his merry band to alter course sooner rather than later because once again, this time in the opposite direction to what happened in 2007/8, fiscal policy is being distinctly unhelpful to the monetary authorities.

Those actions by Congress and their impact also explain why this move is destined to end before long. The political situation makes it extremely likely that whatever the Fed does, and whenever they do it, America will be hit harder than most by inflation. The dollar will lose intrinsic value and will have to decline.

The dollar’s strength over the last few months, and the return to weakness last week, make little sense on the surface in an inflationary environment. However, in the circumstances and as compared to other currencies, it makes perfect sense. However, those same factors also point to a reversal before long, so over the next few days I will be taking a few trades such as long crude and other commodities that will pay off when that comes.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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