On Wall Street, it's best not to think too hard or to look too closely into the mouths of gift horses. Since making predictions based on actual economic understanding is rare, analysts typically look to provide explanations after the fact. Within the financial services industry, currency traders are perhaps the greatest practitioners of this craft. While they often get the fundamentals completely wrong, it never seems to stop them from offering bizarre theories to explain currency movements.
After the Recession of 2001-2002, the dollar began an historic, nearly 40%, decline that bottomed out in early 2008. During that time, the falling dollar became a dominant topic in the financial world. While it was occurring, I argued that the sell-off was the result of the overly accommodating monetary policies of the Alan Greenspan-led Federal Reserve and the rapid increase of Federal debt under George W. Bush. Few currency traders agreed. Instead, most continually predicted that the slide would end long before it actually did. Their confidence may have been based on the fact that the Federal Reserve raised rates from 2003 to 2007. According to the textbooks, rising rates, which reward someone for holding a particular currency, are supposed to be a positive. Except, that time, they weren't. I argued that the rate increases were too mild to actually strengthen the dollar and too slow to deflate the growing bubbles in stocks and real estate. Eventually the dollar decline stopped, but it took the chaos of the 2008 financial crisis to bring it about.
After two and a half years of intense volatility that followed the aftermath of that crisis, the dollar settled into a long uptrend that began in April 2011 that has since added more than 30% to its value. When the rally started, traders attributed it to the first hints that the Fed would be winding down its Quantitative Easing bond buying program (which had been in effect since 2008). Even though those purchases didn't fully end until 2015, just the thought that the program would be slowing inspired traders to buy the dollar. When QE came to an end, their anticipation then shifted to the Fed's decision to lift interest rates from zero, a move that finally occurred in December 2015. Since then, they have attributed the rally to the rate hikes of 2017 and 2018 and the future hikes the Fed has said it intends to deliver this year and next.
But during the entire rally, interest rates have remained below even the official rate of inflation, and America's trade and budget deficits have kept expanding. Those factors should have dragged the dollar down. Instead, political troubles in the European Union and economic uncertainty in Asia, combined with massive central bank purchases of Treasury bonds, helped push up the dollar for unearned reasons. But as long as the trends conformed to their forecasts, no one questioned the causality.
When 2017 began, bullish consensus on the dollar was off the charts. Yet despite multiple rate hikes throughout the year, the dollar defied consensus and fell sharply, notching its first annual decline in five years, and it's largest yearly drop in fourteen. But following its worst January since 1987, the dollar has since risen by about 7% from its February low. To explain the turnaround, traders are now making similarly bad arguments and are extrapolating continued gains into the future. Incredibly, included among their bullish arguments are soaring federal budget deficits and the prospects for a protracted trade war. But they are wrong that those factors will help the dollar.