The expansion of the Fed's balance sheet results in a rising US dollar

A prevalent notion is that the Fed expanding its balance sheet (QE) equates to a lower dollar. After-all, they purchase assets by “printing” dollars, expanding the dollar’s supply, so it makes sense that the dollar would fall. But, let’s take a closer look at this idea. If you look below, I have a chart of the Fed’s balance sheet alongside the trade weighted dollar index. Since the Fed began expanding their balance sheet in 2008, there is a clear positive relationship with the Fed’s balance sheet and the dollar. When the Fed expands its balance sheet, the dollar goes up and when the Fed’s balance sheet stays flat, the dollar ranges. Over the last several months, the Fed’s balance sheet has expanded, but the dollar has fallen, creating a divergence. If the positive correlation between the two is going to come back together, that means one of two things will happen: the Fed’s balance sheet will contract (not going to happen) or the dollar is going to rise. My money is on the latter of the two. This divergence suggests to me that the dollar is in a corrective phase and it will rejoin the Fed’s balance sheet to the upside, like it has every time since 2008.

Now, if the expansion of the Fed’s balance sheet is increasing the money supply, why would the dollar rise? If the Fed is expanding its balance sheet, that is not a good sign. That means there are liquidity holes in the system that the Fed is trying to plug by “printing” money. There is lack of liquidity because it is being destroyed somewhere in the system. As a side note, when I say destroyed I’m talking about liquidity drying up due to credit defaults, banks tightening lending standards, etc. If you look (below) at the H.8 data (commercial banks assets and liabilities), you will see that credit has contracted about $460 billion since May. Now, the Fed has “printed” a couple trillion, but this data does not take into consideration the dollars that have been destroyed in the eurodollar (not EURUSD) market. If the Fed must continually expand their balance sheet, it means dollars are getting destroyed at a faster rate than the Fed has been able to put them back into the system. The eurodollar market is vastly bigger than the domestic US dollar market. A couple of trillion dollars from the Fed is a relatively small percentage of the eurodollar market. You may be thinking, then why doesn’t the Fed print more? Well, first, they will, but the eurodollar market is neither on the Fed’s radar nor is it a measurable market due to its vastness and elusiveness; therefore, it is not included in the money supply (I spoke more about the eurodollar market and money supply here). So, if the Fed is expanding its balance sheet, it means dollars are being destroyed elsewhere at a faster rate, hence the positive relationship we have seen the last 13 years between the dollar and the Fed’s balance sheet. I expect this trend to continue.