The Sliding Dollar or the illusion of trade balance

The dollar has taken a trajectory that few predicted rightly before the Fed initiated the tightening cycle; Goldman Sachs to Morgan Stanley, almost all the forecasters got it wrong and they saw dollar gaining against a basket of currencies, which is just the opposite we have seen in recent times.

From Chinese Yuan to Euro, including the Indian Rupee, we see a rebound quite unexpected. But every currency has a different reason for hardening against the dollar; the general balancing of trade in commodities notwithstanding.

First of all foreign exchange trading across the world sees $5.4 Trillion changing hands everyday according to this BIS paper, a number that dwarfs every activity in stock exchanges round the globe. The reason for such spate of activities can be found in the amount of liquidity that these markets can absorb and large proportion of trades are steered by speculators, which is quite different from the other trading systems where institutional players hold the bulk of the pole.

85% of Forex Trading happens in dollars, which means that when the dollar loses steam, these markets have more short sellers.

The dollar strength is governed by the general sense of the direction of U.S. economy against the other leading economies. There is reason to believe that the Chinese economy has silently moved forward with a spate of reforms with the closing of polluting industries, change in the monetary policy and hardening of the interest rates as inflationary pressures appeared round the corner.

The hardening of the commodity prices has seen an unequivocal pattern almost coinciding with the industry closures in mining and metals in China. The world trade balance needed dollar to loosen and it did or is it an illusion waiting to be challenged?

The European economy made a silent uptick as well in the last two quarters, whereas the U.S. economy failed to take off although unemployment has remained at the lowest level.

The tax reforms failed to take off and there were mixed signals on trade which confused more than it could impose.

The Fed on the other hand remained nuanced between actions in a tightening cycle and a large balance sheet that needed to shred its assets as well as its liabilities.

The trillion dollar of excess reserves sitting on Fed's liability side of the balance sheet continues to absorb interest liabilities to commercial banks while selling securities that the Fed mopped up during the crisis needed a slower curve of acceptance by the rest of the financial system; neither of this boded well for the dollar.

The dollar is lighter and waiting for signals; for the time being it looks more vulnerable than it was a couple of quarters back. It definitely provides a cushion for commodities denominated in dollars, but whether one gains or not would depend on which side of the trade you are in.

Finally it will be economy, as always, that would guide.