The U.S. dollar was in a bear market from February 1985 to the end of 1990. Here’s the USD Index (all values multiplied by 100x to eliminate decimals).
This bull market had 3 stages:
- The major decline lasted from February 1985 to the end of 1987.
- The U.S. Dollar Index had a big bounce from the beginning of 1988 to mid-1989.
- The second decline lasted from mid-1989 to the end of 1990.
Money Flow ultimately determines the U.S. dollar’s bull and bear markets.
- When money isn’t decisively flowing in one country’s direction, the USD Index swings sideways in a massive range.
- When money is decisively flowing towards the U.S., the USD is in a big bull market.
- When money is decisively flowing out of the U.S. to a major foreign economic power, the USD is in a bear market.
Money Flow is impacted by many factors:
- Interest rate differentials
- Differences in economic conditions
- Differences in economic opportunities
- Differences in political safety.
- Inflation (click here to see how inflation impacts the U.S. Dollar).
Various stages of this USD bear market were driven by different money flow factors.
Money Flow to Japan: 1985-1987
Money Flow went decisively to Japan in the second half of the 1980s. This is why the U.S. Dollar was in a massive downtrend.
This Money Flow was purely driven by a multi-year asset bubble in Japan (Japanese stocks, real estate, etc). Profit opportunities in Japan were shrinking by the second half of the 1980s.
*From 1988-1990, Japan was purely in an asset bubble. Japanese economic growth peaked in 1986.
The fiercest leg of the Japanese bull market in equities was from 1985 to October 1987. Although the Japanese stock market continued to climb higher from 1988-1990, the magnitude of its ascent slowed down.
Here’s the Nikkei 225, log scale.
This Money Flow matches with USDJPY, which made a big medium term bottom in February 1988.
During this period, the go-go years of Reagan’s first term was over. U.S. economic growth peaked and slowly deteriorated from 1986-1990. (Recession in 1990.)
Government action failed
The G5’s selling of U.S. dollars caused the USD to top in early-1985. The G7 (excluding Italy) signed the Louvre Accord on February 22, 1987 to stop the USD’s decline.
This is because when the G5 signed the September 1985 Plaza Accord, they “wanted” to see the U.S. Dollar fall 40%. By February 1987, the USD Index was indeed 40% below its 1985 high of 162.
HOWEVER, this accord failed to stop the USD’s decline because it was completely different from the action taken in 1985.
- In 1985, global central banks sold U.S. dollars in unison. They directly intervened in the forex markets.
- In the Louvre Accord, the G7 tried to indirectly influence the forex markets via adjusting their economies.
Here’s an excerpt from the Louvre Accord
France agreed to reduce its budget deficits by 1% of GDP and cut taxes by the same amount for corporations and individuals. Japan would reduce its trade surplus and cut interest rates. Britain would agree to reduce public expenditures and reduce taxes. Germany, the real object of this agreement because of its leading economic position in Europe, would agree to reduce public spending, cut taxes for individuals and corporations, and keep interest rates low. The United States would agree to reduce its fiscal 1988 deficit to 2.3% of GDP from an estimated 3.9% in 1987, reduce government spending by 1% in 1988 and keep interest rates low.
As you can see, only direct action in the forex markets can influence the USD. Indirect actions failed.
Meanwhile, U.S. inflation soared in 1987 thanks to Reagan’s massive tax overhaul/cut. Historically, a surge in inflation = a flat USD or a falling USD. The USD fell in 1987.
Why the U.S. Dollar rallied from April 1988 to June 1989
Once again, interest rate differentials caused Money Flow to go to the U.S.. Keep in mind that this was not a very big rally, so it might have just been a technical bounce from extremely oversold levels. The bounce only brought the USD up to its 23.6% fibonacci retracement.
By 1987, U.S. and German interest rates were approximately the same: 6%.
- From April 1988 to May 1989, the Federal Reserve hiked rates aggressively.
- During this period, German interest rates did not go up at all.
Hence, there was a significant difference in interest rates: almost 3%. Interest rate differentials impact Money Flow only when the differentials are high. Differentials of e.g. 1, 2% are meaningless.
Here’s the Fed Funds Target rate
Here’s the German 10 year government bond yield during that period.
June 1989 to the end of 1990
The U.S. dollar sank again. This was the 2nd and final leg of the USD’s bear market. 3 Money Flow themes caused the USD’s downtrend.
- The Japanese asset bubble continued to rise. This attracted Money Flow from the U.S. and other countries. Domestic Japanese money poured into Japanese real estate, and international money poured into Japanese stocks.
- The economic slowdown in the late-1980s was primarily U.S.-driven. When the U.S. economy leads the global economy’s slowdown (e.g. 2007), the USD falls as Money Flow chases better business opportunities in other countries.
- Interest rate differentials. As the U.S. economy slowed down significantly in 1989 (recession in 1990), the Federal Reserve cut interest rates. Meanwhile, Germany was hiking interest rates as they grappled with high inflation.
Here’s the Fed Funds rate.
Here’s the German 10 year government bond yield.
Here’s German inflation.