Correlation: Trade Balance Vs. Currency Strength

As predicted in this article, the improving trade deficit numbers in the U.S. weren't going to last. It is now flatlined (2014).This brings me to a new correlation.

The trade deficit is correlated to the U.S. dollar.

The following chart gives the monthly U.S. trade deficit (red chart) Vs. the U.S. dollar index (blue chart). If the trade deficit widens (red chart goes down), the U.S. dollar index will drop (blue chart goes down).

As you know, a trade deficit means that imports exceed exports. Americans buy more stuff from foreigners and in exchange they give money to these foreigners. This money needs to be in the currency of the foreigners. Let's say an American buys a Chinese TV. He will have to pay yuan to the Chinese merchant. To do this, he will convert U.S. dollars to yuan. This will lower the value of the U.S. dollar.

The other way round is also true. China has a trade surplus and will sell its goods to America in exchange for U.S. dollars. These U.S. dollars will be converted to yuan, otherwise the Chinese merchant can't do much with the U.S. dollars in his country. This will increase the value of the yuan.

Of course, there is a lag between trade and currency conversion. This lag is approximately 1 year. As a consequence, the trade balance is a leading indicator for the strength of a currency. The higher the U.S. trade deficit, the more probable that the U.S. dollar will go down in value.

Recently, the trade deficit has improved a lot since 2010, the U.S. dollar strengthened with it. But I believe this improving trade balance has started to roll over.

To show that this correlation is valid, I will give another example: Japan. Macro Man's blog indicates that the Japanese yen is about to collapse if we look at their trade deficit numbers. As the blue chart goes down, the yen should weaken considerably.

If you know that the trade deficit is a leading indicator for currency weakness, you can predict the collapse of the U.S. dollar by just looking at the trade deficit trend. You can position yourself for this collapse in the U.S. dollar by buying precious metals and commodities.

Moreover, when the U.S. dollar goes down, the imports will be more expensive and the exports less expensive, which will add to the trade deficit.

The following chart shows the current account deficit + budget deficit against the U.S. dollar. Also here we see a correlation (although the gap has widened in 2019).