USD Underwater.

Last Tuesday, the Federal Reserve signalled they were hell-bent on pursuing an “inflate or die” approach to rescuing the ailing US economy and fending off the forces of deflation. The Fed is now inflating at a level possibly not seen by a developed nation since Weimar Germany.

Since the credit crisis started intensifying in July, the dollar benefited from a global flight to safety in US Treasuries and a scramble for dollars to repay dollar-denominated debt. The deleveraging process effectively created a huge short position in the greenback.

But more recently, US-specific worries concerned with public debt expansion and the potential inflationary implications of quantitative easing dawned upon battle-weary investors, causing the dollar to reverse the uptrend that had commenced in July.

The US Dollar Index (i.e. a trade-weighted basket) has not only breached its 50-day moving average convincingly, but seems to be forming a top of at least medium-term significance. The fall from grace was brutal with the Index recording its largest six-day decline (from December 10th to 17th) ever, setting up an assault on the key 200-day line (often seen as a crude indicator of the primary trend).

The US currency also suffered its biggest one-day slide against the euro on Tuesday, and plunged to a 13-year low against the Japanese yen.

The devaluation of the US dollar (de facto exports deflation and depression) raises the question of how long it will take before other countries retaliate and embark on a “beggar thy neighbor” currency debasement.

China is already in the process of “managing” the renminbi lower, Russia’s central bank has signaled it would step up devaluation, and the Bank of Japan and others might also consider intervention.

Either the U.S. is going to pay for their policy sins via higher interest rates or via a weaker dollar. And for an economy as levered as the one in the US, the former choice is not an option. So a weaker dollar is the natural valve.

US creditors -- such as China -- with large hoards of dollars are growing increasingly nervous, and the dollar is likely to come under additional pressure if foreigners stop finding dollar assets an attractive proposition. The only way the US can attract foreign capital is by offering a higher interest rate or making its assets cheaper through a weaker currency.

Jim Rogers commented:

“The dollar is a terribly flawed currency... I don't like to do it, but I'm going to sell all the rest of my dollars sometime in the next few days, weeks, or months… "Again, I don't like saying it, but I'm afraid the dollar is going to go the way the pound sterling went."

The speed of the dollar's decline has been such that it's quite likely to see a relief rally before the downtrend resumes.

Arguing for a temporary hiatus from a fundamental viewpoint, right now, real competition in this ugly contest [is coming] from the currencies of the European Union and the United Kingdom, and that will probably persist for a while... But they're in pretty bad shape, and they're a little bit behind the curve relative to the U.S.

Lastly, a sustained break in the uptrends of the US dollar and the Japanese yen -- low-yielding currencies previously used for funding risky investments -- should indicate that forced selling due to deleveraging is starting to subside. As this situation plays itself out, we should see a return of confidence and a calmer period for stock markets in general, and also some support for precious metals and commodities.

The dollar may be down for the count, but could herald a sense of normalcy in broader markets.