For the greater part of five weeks now, the US Dollar has been on the back foot in its pairings with the currency majors. A look at the charts of the pairing of the greenback with the Euro, Australian Dollar, New Zealand Dollar, Canadian Dollar as well as the British Pound to a lesser degree, all reveal significant weakening of the US Dollar.
The weakening of the US Dollar is easily captured by the downtrend in the USD index (DXY) as showcased in the chart below:
Downtrend in USD Index Shows Softer US Dollar
So why is the greenback weakening against its peers?
An understand of why the US Dollar is weakening against the currency majors requires some knowledge of the workings of market economics and the fundamentals backing each of these currencies. Whether you want to start trading on the stock market or you want to trade FX or CFD assets, this knowledge will remain relevant. The fundamentals always direct market action and the direction of each currency. Securing proper entries and exits according to the market direction is where technical analysis comes in.
There are two principal reasons behind the weakening of the US Dollar in relation to the currency majors mentioned above. These reasons have to do with:
a. The stimulus packages of the US government, channeled through the US Federal Reserve
b. Recovery or risky sentiment in response to the global stimulus packages and the easing of the coronavirus-related movement and travel restrictions imposed in March/April 2020.
Federal Reserve’s Money Supply Actions
The US government has initiated several funding windows to support businesses in order to help them recover from the losses caused by the COVID-19 pandemic. The CARES Act is one of the several initiatives launched by the US government in this regard. Under the various funding initiatives, trillions of dollars will be pumped into the US economy and made available for all categories of businesses. Credit will be provided, all guaranteed by the Federal Reserve.
The Federal Reserve is the only authority in the world that controls the supply of the US Dollar. To finance these programs, it simply needs to print more of the greenback. Such a massive injection of supply of the US Dollar into the system will do one thing: reduce its value, according to basic supply and demand economics. So with trillions of US Dollars being printed, there is bound to be a supply-based weakening of the greenback. But this is not all there is to it.
The interest rate reductions by the Fed mean that the cost of credit has been eroded. Record low interest rates means that acquiring the US Dollar in a credit facility comes at virtually no cost to the user or borrower. This also means that money market instruments that are USD-denominated (such as Treasuries) will not attract much of a yield for investment money. Investment money always seeks avenues where it gets the greatest returns. At the moment, USD-denominated money market instruments will not offer this. Therefore, investment money will move away from channels of low returns, to areas of high returns. Such a shift means that institutional market participants will offload US Dollars into the market, in order to acquire foreign currencies of countries that could guarantee higher investment yield. When a currency is sold off in such large quantities, we will see increased supply which reduces the value of such a currency. This is what is happening to the US Dollar at the moment.
Increasing Risk Sentiment
As the world economy gradually reopens, investment money is going to shift away from the safe-haven assets and into riskier assets. The US Dollar is regarded as a safe-haven currency, and as lockdowns end across the world and businesses restart, we will see investment money shift into the currencies linked with the risky commodity assets, and we will also see lesser demand for the US Dollar when compared to its peers. There are clear examples to show that this is already happening.
a. USDCAD
The Canadian Dollar is regarded as a commodity currency, because it has a positive correlation to the price of crude oil. Canada’s crude oil correlation is as a result of its being the country with the 2nd largest crude oil reserves in the world after Saudi Arabia. It is also a net exporter of crude oil.
The USDCAD therefore represents a pair featuring a safe-haven currency (USD) and a risky asset-linked currency (CAD). In the last two months, the Canadian Dollar has gained ground against the USD, as crude oil prices have nearly doubled in that time frame. Furthermore, the shift towards risky sentiment has weighed heavily against the US Dollar in this pairing.
USDCAD 1D Chart: Move to Safety (USD-positive) vs Move to Risk (CAD-positive)
We can see from the chart that when COVID-19 set in between January and March 2020 when it was at its peak and markets were in turmoil, the US Dollar gained significantly against the Canadian Dollar. This was when flight to safety by investment money was seen. But as the world economy started to reopen, investment money began to shift away from the US Dollar and into the Canadian Dollar and other risky currencies and commodity assets such as crude oil, copper and the Aussie Dollar.
b. AUDUSD
Speaking of the commodity-linked Australian Dollar, we can also see the same move towards risky sentiment playing out, with the Aussie Dollar gaining quite a bit against the US Dollar.
AUDUSD 1D Chart Showing Risk-off (USD-positive) and Risk-On (AUD-positive) Sentiment
Just like Canada, the Australian economy is heavily commodity-based, as it exports gold, copper and other industrial raw materials to China and other Asian countries. When COVID-19 hit, the Aussie Dollar bore the full brunt of risk-off sentiment, as investment money poured into the USD and caused the AUD to lose ground to the greenback. However, a reopening of the global economy, followed by a 4% increase in copper demand by China, has set off a return to the risk-on sentiment, causing investment money to flor back into the Australian Dollar at the expense of its American counterpart. The chart above says it all.
Conclusion
The weakness of the US Dollar can be attributed to the shift in market bias to that of a risk-on sentiment, as the global economy reawakens from the enforced shutdowns of March and April 2020.
Furthermore, near-zero interest rates have also reduced the cost of credit and the yield for investment money. Investment money always seeks avenues that guarantee higher returns. So a shift away from USD-denominated assets is to be expected at this time.
These are the mechanisms that have weakened the US Dollar. Analysts at Goldman Sachs have predicted in a recent report, that the US Dollar could still weaken significantly if the market fundamentals remain as they are. Once the sentiment changes, the US Dollar may find some opportunities to strengthen once more.
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