Ready for Another USD Rally?

June 19, 2020
By Steven Vannelli, CFA in Economy, Markets

As funding strains appeared in March, the USD surged. Then the Fed stepped in with massive foreign exchange swaps as a way to lend USD to foreign central banks, intended to ultimately be lent to borrowers in need of USD. As F/X swaps reached almost $500 billion, allocated heavily to Japan and Europe, the USD experienced a 7% correction, from 1,300 on the BBDXY to 1,200.

Now, as liquidity strains have been addressed, the F/X swaps are rolling off, leading to an outright decline in the Fed’s balance sheet last week. As the swaps roll off, the USD is rising again, up about 2% in the last couple weeks.

In our opinion, had the F/X swaps not occurred the USD was naturally on a glide path higher as petroleum inventories went through the roof. The BBDXY has a pretty good historic fit with the inventory of petroleum products—both crude and refined—not including the Strategic Petroleum Reserve (SPR).

To give some perspective on the distortions the COVID-19 crisis has created in the energy markets, US gasoline inventories are totally out of whack from a seasonal standpoint. Inventories tend to peak in the winter and draw through the fall as driving picks up with warmer weather.

With daily gasoline demand still some 20% below year-ago levels, inventories in June are hanging around the highs for the year, while they should be down around 100-200 million barrels from winter peaks.

The level of petroleum inventories suggests the BBDXY at 1,300, or about 5% higher from here. If the F/X swaps are sunsetting, then perhaps fundamentals may re-assert themselves and we should be ready for a continuation of the USD rally.

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