USD is losing the currency beauty pageant

Currency markets are the ultimate real-time poll on the performance of an economy.

The daily direction of a country’s currency is like a continuous referendum on the trajectory and prospects of the country’s economy. Every day, the US$5 trillion worth of currency that changes hands in foreign exchange (forex) markets, are the oil that greases the wheels of international finance. Forex trading volume dwarfs stock and bond transactions… where around US$300 billion and US$700 billion, respectively, is traded daily.

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So when a currency is weakening against other currencies, it's a bad sign. It means that there are more sellers of the currency than buyers - and that investors in aggregate are deciding to sell one currency in favour of others. This reflects a lack of confidence in the future of the currency they're selling.

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The U.S. dollar is losing the currency beauty pageant

And in this case, the U.S. dollar is the currency that's having the stuffing beaten out of it.

In 2017 through the end of July, the U.S. dollar had its worst stretch relative to other major global currencies in three decades.

The U.S. dollar index measures the value of the currency against a basket of six major currencies, including the pound, the euro and the Swiss franc. The index has declined for the past five straight months... and it's down 9 percent so far in 2017, as the graph below shows.

That's the worst performance since 1986, when the index fell 12.5 percent over the first seven months of the year. (Remember... in currency markets, not everyone can win. Stocks can rise without another stock falling - in a rising market, everyone can win. But currencies move relative to each other - so for every currency pair, one rises relative to the other - which means that the other currency falls in value. Currencies are a zero-sum game.)

The story is similar for the U.S. dollar against major Asian currencies. China's renminbi is up 3 percent over the last seven months against the dollar, and both the South Korean won and the Singapore dollar are up 7 percent, as the graph below shows. Only the Hong Kong dollar, which is pegged to the U.S. dollar, has barely moved.

Why is the dollar falling?

The U.S. dollar may be losing some of its shine as a "safe haven" currency. When the U.S. itself is a source of heightened uncertainty in global geopolitics and markets, the U.S. dollar becomes less desirable as a currency to be held in times of uncertainty. The decline in the U.S. dollar is a reflection of deteriorating confidence in the country on the part of global investors.

But that's only part of it. To ascribe massive shifts of trillions of dollars to psychological factors is to tread on shaky ground.

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At least as important is that a lot of dollar weakness has been driven by a decline in the Fed Funds target rate expectations. (The Fed funds rate is one of the most-watched interest rates in the world. It's the interest rate that banks charge each other for overnight loans. When people talk about "the Fed raising interest rates," they're really talking about the Fed funds rate.)

All else being equal, money flows to where it's treated best - in other words, where it pays the most interest.

In mid-2016, the Federal Reserves Board of Governors median forecast for the Fed Funds rate at the end of 2017 was 1.625 percent.

The Fed funds rate isn't a single rate, it's actually a range which is 0.25 percent wide - so a 1.625 percent forecast really means a forecast range of 1.50 to 1.75 percent.

However, in June of this year, the updated forecast for the Fed Funds rate at the end of 2017 was 1.375 percent (i.e. a range of 1.25 to 1.50 percent). With the current range being 1.00 to 1.25 percent, the Fed is now forecasting juat one further rate hike in 2017 which is one less than they had anticipated last year.

Likewise the 2018 forecast was revised down from 2.375 percent to 2.125 percent.

Why have expectations for interest rates fallen? We wrote about this recently... in short, because inflation expectations have fallen.

When Donald Trump became president, he talked a lot about tax cuts and infrastructure spending. Both of these measures inject more cash into the economy - and tend to drive up inflation. But these haven't happened, and look unlikely to anytime soon. As a result, expectations of inflation have fallen... and, along with it, the value of the U.S. dollar.

What can you do about it?

We've written before about the importance of diversification... and how investors who have all their eggs in one basket (often their home market) are putting their portfolios at risk. It's the same for currencies. If all of your wealth is in one currency, you're putting your portfolio at risk when that currency declines in value - because your relative buying power will fall. That's the case for investors in the U.S. dollar right now.