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31.07.202216:33 Forex Analysis & Reviews: The dollar is not suitable for investors as a safe haven - not anymore

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In this turbulent year, bulls have little choice. The brighter the American currency broke out into favorites, putting both the euro, the pound, and the yen on the shoulder blades. Nevertheless, if you look at the root of growth, it is noticeable that this growth is not quite normal. This means that as soon as the recession comes to an end, it can lose a lot, failing the entire annual trading plan, even if it previously made a profit on growth.

The dollar is not suitable for investors as a safe haven - not anymore

It's hard not to agree that, despite all of America's many problems, its currency has arguably been the best investment in the world over the past year, showing a truly epic rally.

This is partly due to an unavoidable factor: we are following several of our favorite pairs, and of course the dollar is included there as the world equivalent of commodity transactions. In other words, the US dollar is the "main reserve currency in the world" and the medium of exchange for almost every transaction under the sun.

Its outstanding status is at the heart of the Dollar Milkshake Theory, which is outlined by Brent Johnson of Santiago Capital. In his opinion, all currencies are doomed to secondary roles, because they are not really valuable. In fact, the same notorious principle of "5-7 objects in one head" works for traders. We once said that a trader is limited by the human factor. With regard to the ability to focus, this means that at the same time you can keep the focus on five, maximum, seven pairs of traded assets. If you try to connect more, your attention will inevitably dissipate and you will lose concentration, which is fraught with losses. This phenomenon forces us to simplify processes.

In fact, it is thanks to our desire to reduce the number of objects that need to be tracked that the dollar broke out into the kings. We are also tracking the euro, yen, pound... and a couple of our favorites. Admit it, your trading strategies concern exactly 60 percent of them, right?

And yet the dollar gets the lion's share of attention.

Simply because it is enough for most non-traders to track the main events in the dollar... and the rest is output, relatively speaking, by arithmetic average. In an attempt to reach the widest public, newspapers print news consisting of 40% of events from the life of the dollar.

We don't want to learn forty languages in order to communicate with representatives of most countries. After all, it is much easier for everyone to learn English and communicate freely in any country. For the same reason we want McDonald's: the city is different – the food is the same.

In other words, the dollar is the Johnny Depp of the financial world: at times its reputation suffers, as does the reputation of your favorite calorie burgers, but we resurrect Johnny again and again because he fascinates us, and in general, Captain Jack Sparrow is a legend, damn it!

Let's not forget that all fiat currencies have disadvantages and are ultimately doomed to obsolescence, because they are rooted in debt and are not backed by any absolute means of saving. This also applies to the dollar, but the dollar has fewer disadvantages than others, because it is the main world reserve currency. In other words, its reliability is ensured not by collateral, but by contracts, as a credit specialist would say.

There is an additional factor.

That same milk foam from a cocktail is a cheap dollar, its entire mass, which has additionally come into circulation over the past two years. Even when we blow off this foam from our portfolio, excuse me, this cocktail, the demand for those dollars that are still in circulation still remains, and sometimes even grows. Just like now.

Indeed, even a cursory glance will convince any skeptic that the dollar is marching like an iron march through the world's economies. For example, the Bloomberg Dollar Spot Index has risen by as much as 16% since May 2021, and retail investors are desperately chasing dollars, as they once were chasing meme stocks.

The bottom line is that when the Fed begins to take liquidity out of the system through quantitative tightening, it becomes a net seller of US Treasury securities, which serves to limit the amount of dollars in circulation. At the same time, there is a growing demand for dollars among borrowers who need them to pay interest on a huge amount of dollar debt.

This is how it looks in the first approximation, so a huge number of traders have bet on the US currency.

And in a sense, this is a rather strange situation, undoubtedly originating in a huge army of retail traders who prefer its pairs. Strange, because if it succeeded, the rest of the currencies would simply cease to exist, since they would not be in demand at all. Of course, I exaggerate. But the message, I think, is clear: the market for dollars exists as long as there is a market for other currencies. They are too connected to show the endless growth of only one of them.

It looks even stranger, because many economies feel no weaker than America in terms of real GDP growth. The same Japan enjoys all the advantages from the proximity of other Asian countries - sources of minerals, and is going to please us with an excellent trade balance for the year (not least due to the weak yen).

It may seem counterintuitive to the thoughtful trader that the dollar is rising when all the analysts are saying that the US recession is inevitable, if it hasn't already arrived. The reason for the increase may be that inflation rates are high and the Federal Reserve is more aggressive than other major central banks in tightening monetary policy to fight inflation. This makes US interest rates much higher and more attractive than anywhere else in the developed world, drawing money towards the dollar. Essentially, dollar strength is simply a function of interest rate differentials, as is the case with most currency movements, meaning it is purely speculative and undeniably temporary (which is what makes carry trading super popular this year).

What can lead to the cessation of the dollar's growth and the weakening of the currency?

First, if the Fed suddenly begins to ease monetary policy, which will return dollars to the financial system.

Interestingly, the dollar has been down slightly over the last few trading sessions, possibly due to speculation that the Fed might have to start cutting rates at some point next year due to a recession, or that the rally needs a break after the euro fell below parity against the dollar for the first time since 2002. While I think the markets just took profits, we are at the end of the month after all. The dollar will rise again... before falling.

In fact, this happens every time after a long and major growth: in 2016, after a sharp six-month growth, the dollar sank hard by September 2017, and below the lows of 2016. History in miniature repeated itself in the last quarter of 2017, pulling back below the low in January 2018. This is a direct consequence of the trade war with China. And although right now the bright future of China is even more in doubt due to new possible lockdowns, the Chinese have production facilities in place, and they will definitely not be ready to lose pieces of the markets.

Don't forget also about the spillovers from other economies, which are now suffering not only from falling demand and disrupted supply chains, but also from a strong dollar. Like circles on the water from many stones, they immediately float on each other and extinguish. The dollar's growth will also be limited by the difficult economic situation in the rest of the world, as if it were happening at home: the same drop in demand for American goods. Demand for the dollar for international contracts will also fall, because there will be fewer of them. Bankruptcy on the external debt of third world countries will also reduce the demand for the dollar... inflation and a drop in purchasing power among the Americans themselves will complete the job.

All this makes me doubt whether the dollar can be considered as a safe haven at all? Undoubtedly, in comparison with the Thai baht - yes. But with the Indian rupee - you can already think about it. Because on the day when the rupee moves up, the dollar will lose ground a bit. Each currency will pinch off some investors from it - even outsiders. And it is important not to miss this moment. The brighter the economies of other countries recover, the stronger will be the inflow of investments into them - the inflow that will leave the channel of the dollar.

As a result, perhaps the most dangerous long position at the moment is buying the dollar. And with corrections like on Friday's, so are medium-term ones, especially if you use StopLoss. But for short positions, the dollar is still incomparable. The main thing is not to get hung up on a bullish trend, and everything will work out.

Egor Danilov
Analytical expert of InstaForex
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