Five Factors That Can Determine the Fate of the U.S. Dollar

by: Simit Patel November 11, 2008 | about stocks: DIA / SPY    

Simit Patel

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As many economists and analysts have noted, the stability of the US dollar is a key issue in our current times of economic turbulence. To keep an eye on the stability of the dollar, its value, and how this will affect other markets, there are a few key factors to watch:

1. CDS Prices. Credit default swaps (CDS) can be thought of as default insurance; the buyer makes regular payments, and the seller makes a payoff if the credit instrument in question goes into default. When CDS prices rise, that is an indication that the market is pricing in an increase in the likelihood of default risk. The CDS price for 10 year US Treasury bonds has increased by 2500% over the past year. If the market believes the US government will not be able to pay off its debt, or will have difficulty doing so, it introduces concerns about the stability of the dollar, as it increases the likelihood of the Federal Reserve creating more money to pay off US government obligations.

2. US Government Debt and Deficit Spending. The more deficit spending -- meaning spending that is greater than the revenue the government takes in via taxation -- the more treasury bonds the US government will need to issue to raise capital to finance deficit spending. More deficit spending leads to a greater need for debt, which leads to more Treasury bonds being issued; this could lead to an expansion of the money supply and higher CDS prices, particularly if the Fed continues to seek a low interest rate. Currently US government debt is rising rapidly.

3. Fed Funds Rates. To counter the effect of rising CDS prices, the Federal Reserve may seek a higher Fed Funds target rate to make US debt more appealing, and to counter concerns about a weakening dollar. At this point, however, we still see the Federal Reserve moving in the opposite direction -- towards zero percent interest rates.

4. Money Supply Indicators. Monitoring money supply can also give an indication as to how inflationary forces -- attempts at  expanding the money supply, which can potentially weaken the US dollar -- vs deflationary forces (money supply contractions resulting from credit destruction) can give us an idea of stability issues related to the US dollar. At this time, one money supply indicator that recently turned downward is MZM. Declines in the money supply often correlate to a strengthening of the currency, though demand for money is also a key issue.

5. TED Spread. The TED Spread measures the difference between the rate on three month US Treasury bonds and the rate at which banks will lend to each other. A higher TED Spread indicates banks are trying to pull credit out of the market. High TED spreads also result in the market countering the inflationary actions of the Federal Reserve.  TED spreads have been volatile this year; they are currently declining, which suggests banks are starting to lend again, which is a factor that can lead to money supply expansion.

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This article has 4 comments:

  •  
    Nov 11 02:06 PM
    Excellent article, Mr. Patel. But what is safe to invest in if your dollar is heading toward worthless? Will gold stand up? Commodities? What?
    Reply | Link to Comment
  •  
    Nov 11 04:47 PM
    optionsgirl... Go to Yahoo Finance and pull up a chart for 'SPY' (The SP500 ETF).. Then click on 'compare' and type in 'UUP'.(Dollar bull ETF).. Go back a year. You'll see that as the dollar increased in value, the stock market sank and vice-versa. (In fact, you can use UDN, which is the bear Dollar ETF..And it should track the SPY pretty well.)

    In other words, for the most part, if the dollar devalues, you should expect to see a market revival. You might look at stocks that will do well in inflationary times, or those that suit our new President's inclinations.

    Having said that, I'd be a little leery of Solar stocks or the ETF 'TAN'. It is very likely that we may not have the neccessary cash to move on Solar. You might look at Natural Gas stocks, particularly in their correct season. I'd expect oil stocks to begin to move back up as well.

    Good luck! jegan ;-)
    Reply | Link to Comment
  •  
    Nov 28 10:10 PM
    jegan, that is an incorrect analysis. the market/dollar divergence is strictly because the dollar is still considered the safe haven for all the deleveraging and liquidating going on in the equity markets as asset bubbles collapse (which is why so much selling is occuring). when the last bubble, us foreign debt, finally collapses, the dollar will collapse, all while the market continues its descent (the economy will continue to contract, and a devalued dollar will weaken purchasing power parity, adding to the contraction's effects).

    oil prices will begin to rise again but mainly because it is priced in dollars, which will be declining. oil priced in gold (better indicator of intrinsic price of oil) may even go down, based on demand destruction. oil stocks will not show anything better than a bear bounce, as the commodity bubble of the last 5 years has collapsed and buying stocks in the american equity markets will show no valuable profit (even if you find a way to find stocks that will trend upwards, the profits you are making are in dollars, which would be losing purchasing power, hence lowering your returns, even to a negative level).

    the way to make money is to buy gold and buy bear-biased securities (such as put options, ultrashort ETFs, etc) liquidating their capital gains into swiss francs. this is all long term advice.
    Reply | Link to Comment
  •  
    Nov 28 10:10 PM
    jegan, that is an incorrect analysis. the market/dollar divergence is strictly because the dollar is still considered the safe haven for all the deleveraging and liquidating going on in the equity markets as asset bubbles collapse (which is why so much selling is occuring). when the last bubble, us foreign debt, finally collapses, the dollar will collapse, all while the market continues its descent (the economy will continue to contract, and a devalued dollar will weaken purchasing power parity, adding to the contraction's effects).

    oil prices will begin to rise again but mainly because it is priced in dollars, which will be declining. oil priced in gold (better indicator of intrinsic price of oil) may even go down, based on demand destruction. oil stocks will not show anything better than a bear bounce, as the commodity bubble of the last 5 years has collapsed and buying stocks in the american equity markets will show no valuable profit (even if you find a way to find stocks that will trend upwards, the profits you are making are in dollars, which would be losing purchasing power, hence lowering your returns, even to a negative level).

    the way to make money is to buy gold and buy bear-biased securities (such as put options, ultrashort ETFs, etc) liquidating their capital gains into swiss francs. this is all long term advice.
    Reply | Link to Comment
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