Submitted by RCS Investments
Is the Dollar a Buy? I’m Beginning to Think So!
While developing my outlook on the US dollar, Bob Farrell’s rule
number 9 comes to mind- “When all the experts and forecasts
agree––something else is going to happen”. The number of dollar bears
is disturbing. I find my own forecast moving inversely from the growing
consensus; while I am not officially bullish on the currency yet, the
time may come in short order.
My first reason for beginning to feel bullish boils down to
sentiment. Forecasts for hyperinflation and a falling dollar abound as
gold races higher and it is all but given that quantitative easing will
occur. The “sell the dollar” trade grows more crowded by the day, and
the potential for disappointment is much higher now that everyone
expects quantitative easing. If the Fed proceeds with quantitative
easing we may have a short covering rally as the news is sold and there
is no one left to further sell the dollar. On the opposite end, if the
Fed chooses to delay full scale quantitative easing, that would
certainly be dollar bullish. Continued deterioration in economic
fundamentals leads me to believe we will get some sort of quantitative
easing announcement either in November or in December. However, given
that the first round of quantitative easing hasn’t worked in producing a
sustainable and strong recovery, evidence continues to mount that
sentiment towards continuing this strategy is changing. Various Fed
officials, such as Plosser and Kocherlakota,
are beginning to doubt whether additional quantitative easing will have
much of an effect (interestingly, these two Fed officials will become
voting members of the FOMC next year). Thus, while we may indeed have a
quantitative easing announcement in the coming months, it may not be as
large as the market would like and potential roadblocks may pop up
next year as it becomes clearer that a second round results in a lower
marginal benefit. Everyone seems to be forecasting action amounting to
quantitative easing will lead to hyperinflation, spiking gold, and a
plummeting dollar. The contrarian in me tingles.
Second on my list of reasons to feel more bullish about the US Dollar is a wild-card, but is becoming more probable with every passing day leading up to the mid-terms. The House of Representatives has just passed
a bill amounting to protectionism. Consider that China is still an
export-oriented economy that continues to depend on a lower valued Yuan
to continue its export growth. Their export sector operates on razor
thin margins that would vanish if the Yuan appreciated in a meaningful
way. I spoke about this here.
I believe that if the US and China fell into a trade war, the communist
nation would have more to lose as the nation would no longer have
access to the US consumer to the degree that it had in the past; exports
would fall sharply. Couple this sharp decline in exports with a
possible housing bubble and you would have an even higher probability of
a hard landing for the Chinese. Don’t forget that we have a sentiment
problem here also, as most forecasters expect the yuan would appreciate
should Chinese officials loosen the peg, but in my view, should the
aforementioned protectionist legislation be enacted, the opposite of the
general consensus would occur. The Dollar would rise in value versus
the Yuan as the “China-dependent” global economic recovery would
effectively be derailed. It also bears mentioning that the GOP and Tea
Party movement’s stance on China is even more hard-lined than the
Democrats. With upcoming midyear elections poised to net a conservative
gain in the US Congress, anti-China rhetoric will only increase.
The third reason I’m inclined to shade bullish on the US Dollar is
more secular in nature. While we have seen commodities and other assets
increase in value due to the Fed’s strategy of flooding the system with
money, most of this cash is not making its way into Main Street. Core
CPI as well as pricing metrics in the ISM surveys continue to show that
businesses lack the pricing power necessary to pass on these higher
costs to consumers. While many fear a hyperinflationary event, I see
deflation on Main Street. Households continue to seek cash as
uncertainty in their employment and declining housing prices keep
confidence low. Posh retirement plans have been decimated and many
retirees are finding themselves scrambling for cash as they load up on
fixed income. Main Street is thirsty for cash. Also, when strategic
defaults rise and credit scores subsequently take a beating, debt is not
being paid back. Undergoing a strategic default is akin to making money
vanish. According to the latest “Flow of Funds” data,
debt levels in the US economy are at alarmingly high levels- roughly
$13 trillion in the household sector- and if any of this debt is
defaulted, dollars are essentially destroyed. In formulating their
outlook for the US dollar, many experts concentrate on the supply of
dollars being produced by the Fed’s quantitative easing strategy, but
maybe they should focus more on the destruction of dollars caused by
debt defaults. Another leg lower in housing prices is sure to increase
the probability of strategic defaults rising. Also, the historic
decline in the purchasing power of the dollar has been caused in part by
the expansion of credit. If credit doesn’t expand, dollars are not
being created. Destruction of dollars via strategic defaults and the
end of large credit expansion is a secular reason to feel bullish about
the dollar. Although I wouldn’t say that the dollar is a on the verge
of a secular bull market, these factors are worth considering.
My last two reasons for trending bullish in my outlook for the dollar
are not as substantive, but should leave someone advocating
hyperinflation and the imminent decline of the dollar reconsidering
their position. First, let’s take a look at the value of the Yen.
(Courtesy of Yahoo Finance).
This chart shows an overall strengthening Yen/Dollar relationship
from 1999 to the present. Next, let’s look at an action timeline on the
Bank of Japan. Note that I am only using this chart as a timeline on
the bank’s quantitative easing announcements.
As you can see, during this period of quantitative easing conducted
by the Bank of Japan, we saw the value of the Yen remain mostly constant
from start to finish. Why? One would think that such a strategy would
send the Yen lower, but clearly that’s not what happened. Note that
the dark shaded area in the chart above corresponds to the dark shaded
area in Yen exchange rate chart.
Finally, one last chart here courtesy of Sahil Aliv shows the Fed Funds Rate from 2002 to mid 2010.
We see that the Fed began increasing the rate starting roughly in
April of 2004 and ending around the same time in 2006, plus or minus a
couple of months. During this time the Yen did decrease in value versus
the dollar, but not nearly to the degree that one would expect given
that the Fed was raising its Fed Funds Rate while Japan was in the midst
of quantitative easing (see red shaded box in historical Yen chart).
In fact, the major Yen bottom formed in late 2007 was actually higher
than the one in 2002. Quantitative easing implemented by the Bank of
Japan did not translate to a plunging yen as many forecast the dollar to
do in the near-future.
Finally, if hyperinflation is imminent, then why are Treasuries being
snapped up so furiously? The bond market has always done a better job
at forecasting what the economy will do than stock or commodity markets.
If the value of the dollar was going to plummet, then why aren’t we in
the midst of a bond selloff? Again, look at Japan. The 10 yr rate on
their government-issued debt is under 1%, despite repeated and
inaccurate forecasts for hyperinflation to strike that nation due to its
astronomical debt levels and repeated quantitative easing.
Despite pervasive bearish sentiment, due to the aforementioned
factors, I’m starting to feel more bullish about the US Dollar into
2011. Main Street is saving and paying off debt. Other news points to
strategic defaults becoming the norm. All this implies that Main Street
demands dollars with one hand while the other hand destroys dollars by
defaulting on debt. Ultimately, the fundamentals of the economy are
what move the markets, and the fact that these fundamentals are still
shaky can’t be ignored. If things begin to go awry, the dollar will
still be the safe haven currency. Once again, I am not officially
turning bullish, but it’s making more sense to jump off the boat as it
is pretty crowded.