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Why and When the Dollar Will Fall

January’s market turmoil has very little to do with China but a lot to do with the U.S. The trigger? U.S. interest rates. The dollar is considered a safe haven and is widely expected to rise further. Yet the currency is in a bubble and may soon fall. The signal of when dollar weakness will start will come from China.

We have in front of us an example of one of the most interesting features of modern finance. Market participants have different models of reality to explain events. When mass adherence to a model switches, it can cause sudden market moves — crisis even. The dynamics of such a change in beliefs have driven some of the largest moves ever in asset prices. A key in guessing possible futures is to know what the different views are and who holds them: mapping the structure of investor bases but also the beliefs of different investor types.

There are two major global structural problems: overindebtedness in the developed world and imbalances in the international monetary system. These issues were at the root of the 2008 financial crisis, and they have not yet been fixed. The second problem helped cause the first: Asian savings pushed down the U.S. yield curve and encouraged excessive borrowing. This, on top of lax regulation, led to the 2008 crisis.

Because government intervention was not sufficient, the Federal Reserve saw itself as the only institution between the U.S. economy and full-on depression. A radical, untried program — quantitative easing — was instigated to provide liquidity to banks and push up asset prices so that banks could recapitalize themselves. This action was taken to avoid depression. But to admit as such may itself have caused uncertainty and risked a depression. So central banks have made a distinction between maximum and optimal transparency. They are misleading markets deliberately. Markets haven’t fully understood this yet.

One result of QE has been the large inventory cycle in the U.S. Optimistic firms stock up, only to be disappointed. Hence, we have seen a repeated pattern of healthy growth for a quarter or two, followed by near-zero the next. The data do not indicate strong U.S. recovery yet, although the judicious choice of base time periods continues to fool many. Quantitative easing may have prevented depression, but it did not stimulate the U.S. economy. Consumer prices have remained flat.

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