The Flight to Dollars

After declining against world currencies during 2003 and the first few months of 2004, the U.S. dollar has taken flight. Why has the Greenback started rising in value and how will this play out for investors?

The rise in the value of the U.S. dollar in the past couple of months against the euro and Canadian and Australian dollars is simple to explain.

In mid-March of this year, the huge U.S. bond market started to signal rising interest rates ahead. So what does the smart money do? It exits the bond market because the smart money is worried bonds will fall lower (and it was right!). So where do the exiting bond investors put their money? Not in the stock market, that’s for sure.

The bond investors moved out of the bond market and into immediate term cash investments, such as 30-day T-bills and CDs. This has caused a demand for U.S. dollars, and, like everything, where there is demand, prices will rise.

Similarly, the smart money is out of big-cap stocks. As I read the market, these big volume days on downside action is known among technicians as “distribution”–or the smart money getting out. So where do the exiting stock market investors put their money? Not in the bond market, because these investors are expecting higher rates ahead, which means lower prices for bonds. These investors are going for immediate-term cash investments like 30-day T-bills and CDs, again causing a demand for U.S. dollars.

And finally, there is the perception that U.S. interest rates will rise, giving foreign investors good returns if they hold American dollars.

However, I see this only as an immediate-term phenomenon. While the U.S. dollar could actually move higher here and rally, as more bond and stock investors exit their respective markets, in the long-term, it will be the ballooning U.S. combined government, business, and consumer debt that will again drag the dollar down.

As long-term interest rates rise, Greenspan will have no choice but to flood the system with credit to keep the economy from contracting. The proverbial “printing press” will need to flow “big-time” again, creating too many dollars in the system and bringing the value of the U.S. dollar down. At that point, too many dollars will result in lower prices once more.