Bear case for the dollar

What will drive the US currency? Three events will influence the USD faith:

• Rotation out of Treasuries. Us treasuries are 14 trillion USD market. The single largest owner is the FED with 4.5 trillion. Foreigners own around 65% of the residual paper, with Japanese and Chinese investors leading the rankings.  The trade has been great for them. The US deficit has been shrinking (mainly due to US oil production increases) and therefore treasury issuance has been decreasing. At the same time, FED was buying up most of the new issuance. There were very little treasuries left for investors. All this drove the rates down. Long treasuries was a trade of the past decade. This is now reversing. US tax reform, if approved, will drive the deficit up which will increase the supply of treasuries. At the same time, FED will start to reduce it 4.5 trillion pile of treasuries by 300 bln of treasuries per year. So the treasuries will face a double pressure on rates: due to increasing inflation (driven by imported inflation from EM) and due to an increase of supply of treasuries. Buying treasuries at the time of increasing rates is an unattractive proposition. Foreigners will be most likely selling their Treasuries holdings putting up pressure on USD. As they hold now more than 65% of the treasuries not owned by FED, the wave could be very significant. Both for the yields and for the USD.

• US tax reform. US companies have substantial cash holdings abroad. If the tax reform is enacted, the investors will repatriate their offshore capital holdings back to the US. This will most likely strengthen USD.

• Increase in US interest rates – traditionally, the most important driver for FX is an expectation of interest rates differentials. The most important are 2-year interest rate differentials. If one believes that inflation is starting to emerge, than interest rates will be affected. That would be putting an upward preassure on USD.

The question is which one of the above will prevail. Naturally, it should be the one with the biggest numbers. This means significantly weaker USD due to rotation out of treasuries. I believe that it is already happening. The evidence is in the interest rates. As mentioned it is mainly two years interest rate differentials that drive the rates. The US, two-year rates, are highest levels for the last eight years. Despite that, the USD has been weakening. It might be an indication that the importance of this driving force is lower than the force of the above. Get ready for a rollercoaster ride. 

What could save the USD? Only FED. Hawkish FED. Significant increase in USD interest rates would save the USD. I would not be my money on Hawkish FED.