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Weak dollar? Maybe markets are finally believing the Fed

John Lund | Photographer's Choice | Getty Images

I've been wondering recently: why is the dollar falling? This question disturbs me a lot, because frankly, I thought it was going to continue to rise based on the divergence in monetary policy between the Fed and the other major central banks.

But as it turns out, there is a difference between what the other central banks say and what they do. While the Fed is openly debating whether to begin tapering off the pace at which they expand their balance sheet, in fact several other major central banks have already started shrinking their balance sheets.

(Read more: Blame the Fed for the floundering dollar)

That may prove to be a headwind for the dollar for some time until the difference in monetary policy reasserts itself, probably in the first instance by those central banks that have stopped expanding their balance sheets taking other measures to loosen policy.

The most immediate reason why the dollar is weakening is probably that the Fed has managed to convince the world that tapering off its quantitative easing program has nothing to do with tightening interest rates.

At first the market assumed that "tapering" also meant "hiking" and that short-term interest rates would go up sooner than they had expected. But many Fed officials have tried to clarify that the decision to taper off QE is totally separate from the decision to raise interest rates.

The markets seem to believe this now and rate expectations have fallen back sharply.

(Read more: Fed hawks and doves align; tapering imminent)

For example, the June 2016 Fed Funds futures were implying a rate of 1.82 percent on July 5th, the day they peaked, but have since fallen back to only 1.42 percent, so, down about 40 bps off the highs. This fall in interest rate expectations has naturally hurt the dollar.

Furthermore, a lot of investors seem to worry that the first tapering will be accompanied by some reaffirmation of the dovish outlook, as Mr. Bernanke seems to be taking considerable pains to reassure investors.

But here's the funny thing. In fact, while everyone is worried about when the Fed is going to start tapering off its QE program, in fact several other central banks have already started to taper off.

As the second graph shows, during 2012 the Fed's balance sheet actually shrank while other central banks strongly expanded their balance sheet. The gradual impact of this change may have been one reason for the strength of the dollar this year.

But since the beginning of this year, the Fed's balance sheet is up 23 percent, but the ECB's balance sheet is down 21 percent. Even the Bank of England, which is complaining that the market is too pessimistic with regards to interest rates, has let its balance sheet shrink by 2.4 percent from its peak. Its balance sheet hasn't grown at all this year. The Swiss National Bank balance sheet also peaked in March and has been shrinking since then.

(Read more: Fed and ECB accused of 'muddying the waters')

Meanwhile, the Fed's balance sheet keeps growing, and of course what the FOMC means by "tapering" is just that they will slow the pace of its expansion,not shrink it. So it may be that the tapering argument is not such a strong support for USD in the first place as other countries are doing similar.

Fed/ECB balance sheet vs EUR/USD

The ratio between the Fed and the ECB's balance sheet is now at a record high. The last time the ratio was around this level, EUR/USD was close to 1.50!So this is consistent with a much higher EUR/USD.

Of course, this ratio is not entirely appropriate for the ECB, because in fact the ECB can't really do QE like other central banks do. It's forbidden from buying bonds directly from the market, so it can only expand its balance sheet through lending. If banks don't want to borrow, there's nothing it can do.Recently the banks have been repaying their long-term refinancing operations,with the result that the ECB's balance sheet shrinks.

Fed/BoE balance sheet vs GBP/USD

But the Bank of England does have control over its balance sheet. As it has stopped increasing the amount of its bond purchases outstanding, the Fed's balance sheet has been expanding relative to the BoE's. That too should be pushing GBP/USD higher.

(Read more: Fed vs BoE: Contrast in policy could hit pound)

The case of the Bank of Japan is a bit different. The Bank of Japan's assets are indeed growing faster than the Fed's, and the currency pair has moved appropriately. However USD/JPY has risen much faster than the ratio of the two balance sheets.

BoJ/Fed balance sheet vs USD/JPY

That may be why USD/JPY has fallen back to almost exactly where it was when the Bank of Japan started its quantitative easing even though its balance sheet is already some 20 percent bigger, vs a 12 percent expansion in the Fed's balance sheet over that same time period. However, this ratio is only going to rise further as the BoJ is not going to start tapering for years, and so I think this relationship is likely to hold.

(Read more: Why the Bank of Japan is right to stay 'passive')

In any event, I don't expect the dollar's weakness to last. I think these changes in central bank action are having an impact that is contrary to the banks' intended policy, as we have seen with both the ECB and BoE arguing that the market's implied path of future interest rates is too high.

The ECB and the BoE are trying new methods of easing that don't rely on their balance sheets to rectify this problem. As the Fed moves towards scaling back its emergency loosening in one way or another and these other central banks experiment with new ways of going in the opposite direction, I think the dollar is likely to resume its rise.