I don’t know if the USD Index will consolidate sideways for the next few months or breakdown right now below 90. However, the U.S. dollar is clearly long term bearish.
Money Flow is the fundamental reason for bull and bear markets in forex. Right now, Money Flow is moving away from the USD and towards other currencies.
- Interest rate differentials = bearish for USD’s long term
- Economic differentials = neutral to bearish for USD
- Inflation is coming = bearish for USD
Money Flow: interest rate differentials
Interest rate differentials (spreads) are a key factor to currency pairs.
- When the spread between “Foreign rates” – “U.S. Treasury rates” widen = bearish for USD.
- When the spread between “Foreign rates” – “U.S. Treasury rates” narrow = bullish for USD.
The most important spread is the German Bund – U.S. Treasury. Germany is Europe’s main economic engine, and the EURUSD accounts for 57% of the USD Index.
The USD Index bottomed in 2011, when the German/U.S. 10 year spread started to fall. Here’s the spread.
Here’s the USD Index.
The spread has probably bottomed and will widen over the next few months.
- Germany’s 2 year yield tends to lead its 10 year yield. Hence the 2 year spread tends to lead the 10 year spread.
- The 2 year spread has approached all-time loans. Thus the spread will probably go up in 2018.
- This is a long term bearish factor for the USD.
Here’s the German 2 year yield – U.S. 2 year yield.
Economic growth differentials
Money flows to economies that are growing faster (not just from a GDP perspective). This is because money always wants to take advantage of higher profit opportunities.
Both the U.S. and foreign economies are growing at a healthy and similar pace right now. (U.S. economy, Chinese & German economy). So economic growth differentials are a neutral factor for the U.S. dollar right now.
HOWEVER, there is much more potential for non-U.S. economic growth.
- The U.S. economy bottomed in 2009 and has grown steadily since then. Hence, the U.S. is in the final quarter of this economic expansion (which our Medium-Long Term Model confirms).
- Many non-U.S. economies (China, emerging markets, Germany, Europe) bottomed in late-2015 and early-2016. They are in the early stages of their economic expansions.
If non-U.S. economies growth significantly faster than the U.S. over the next few years, this becomes a bearish factor for the USD.
Inflation is coming
Inflation will rise over the next few years as:
- The U.S. hits “full employment” (unemployment rate is already very low), and…
- Oil prices go up over the long term because U.S. shale costs are increasing.
History shows that when inflation rises, the U.S. dollar falls. Here’s an in depth look at how inflation impacts the USD.