Monday, May 23, 2011

Issue XXVI - US Dollar Rally

Dear Readers,

If Mark Twain were alive today, he could easily reference his own famous quote when speaking about the US Dollar; in short, rumors of the greenback’s death have been greatly exaggerated. After falling well over 15 percent since last June, the US Dollar appears to be setting up for a rebound, if not a multi-year recovery. Amongst all the negative commentary that has surrounded the greenback recently, the fact of that matter is that all fiat currencies will remain under pressure as the US and Europe continue to stagger through difficult financial times. With the looming problems concerning Medicare and Social Security, along with the recent budget impasses, many commentators believe that the Dollar will continue to fall. Over the longer term, this is likely true. Despite this, the impending end of QE2, the potential tightening of monetary policy, and technical signals point toward a bottom. In short, the US Dollar could be ripe for an upward reversal, potentially for the
short-to-medium term.

Even before the onset of the Great Recession and subsequent financial crisis in 2008, the US Dollar was in secular state of decline for most of the 2000s. The expenditures from the Iraq War, low interest rates in the US, massive budget deficits and the Euro coming into its own were among the reasons for the decline. The current massive amount of negativity surrounding the Dollar is being pushed by escalating fears of a potential US Government debt default, rising inflation and interest rates, speculation of a third round of money printing by the Fed, and the potential reduction of importance of the Dollar as the global reserve currency. These fears, while not unwarranted, are overblown and have resulted in the Dollar currently being oversold.

Due to its role as the reserve currency of the world, the performance of the Dollar has a greater effect than many, even seasoned professionals, realize. The value of the Dollar affects the equities markets, commodities, bonds, inflation, consumer confidence, and most of all, macroeconomic policy for not just the US but the rest of the world’s governments and central banks. In other words, economists, politicians, and just about everyone else who monitors financial markets study the Dollar’s movement because of its effects on their subsequent economies, policies, standards of living, and many other factors.

Recently in op-eds or on CNBC and Bloomberg, economists and commentators have covered the bullish and bearish cases thoroughly. First, the bearish argument. Public debt in the United States is already high, and continuing to rise at a staggering pace. On April 18, Standard and Poor’s downgraded the outlook for US government debt to “negative.” This followed a nearly 5% drop in the preceding month as Congress repeatedly failed to agree on the federal budget until the eleventh hour. If a formal downgrade of the US credit rating from the AAA level were to take place, it would immediately trigger selling of US Dollars by central banks around the world. This would likely be a harbinger of the US permanently losing its economic hegemony, although the arguments for and against this are too lengthy to discuss here. At any rate, this stems in part from the devaluation of the US Dollar due to the Federal Reserve’s quantitative easing programs since March 2009. While these programs have not been extended yet, last week Federal Reserve Chairman Ben Bernanke affirmed a commitment to exceptionally low interest rates for an extended period of time. This comes despite the Fed seeming to ignore rising inflation over the past year, as seen already in the prices of food and other everyday commodities. While a part of the rising prices of can be attributed to poor harvests in many food commodities and higher oil prices, the fact is that many economists and citizens alike are concerned that that Fed is counting on price rises to taper off, and are worried it may not happen. Rising prices would only hurt the Dollar more. The end of the Dollar as the world’s preeminent reserve currency could take place if one or a combination of the aforementioned events materialize. Additionally, a main concern of some economists is that if a watershed event such as a US debt downgrade occurred, the process could not be controlled. The Dollar’s decline would be exacerbated by central banks quickly moving to diversify their currency reserves, quickly selling Dollars and moving them into either gold or other currencies. To illustrate this, several prominent commentators have expressed concern at the fact that China holds approximately 70 percent of its reserves in US Dollars, and its future actions could lead the way in diversifying out of the Dollar. The concern stems in part on the fact that such a rapid decline of the Dollar could lead to a currency crisis and potentially hyperinflation.

The positive outlook arguments for the Dollar are largely contrarian in nature, and address the fact that at least a portion of the Dollar’s recent decline can be attributed to overblown fears. First and foremost, it needs to be considered that the extreme level of pessimism may already be priced into the current Dollar Index, which fell to as low as 72.70 last week before rising to close at 74.91 on Friday, a sharp increase that perhaps signals the beginning of a medium-term rally. The droves of investors that have been running to physical gold, silver, or precious metal ETF’s like GLD and SLV have been doing so in part to protect their portfolios from a collapse in the Dollar. While this was a major factor in the price run-up, the events of this past week in the precious metals sphere have revealed that it was at least in part being driven by speculation. Therefore, the rapid run-up and
equally swift decline of precious metals could be indicative that the big drop in the Dollar has already taken place, and it may be near or already has seen a medium-term bottom.

Second, a timely end to the second round of quantitative easing (QE2) could create further headwinds for the stock and precious metals markets. This was the case in 2009-10 with the start and end of the first round of quantitative easing (Refer to Chart 1). Note that the Dollar began to fall in 2009 after the March 2009 announcement of Quantitative Easing, and began to rise once again after the Dubai debt crisis in November 2009, continuing with the European Debt crisis and the end of QE1. The latest round of Quantitative Easing, along with the subsiding (but far from over) debt crisis in Europe, contributed to the Dollar’s slide since last summer that, in my opinion, has led to the Dollar being oversold. Indeed, tighter monetary policy has been argued for by members of Congress and the Federal Reserve Board alike. While the situation in Libya and the rest of the Middle East has contributed to higher oil prices, commodities in general have been rising. Tighter monetary policy in response to this will help ease inflationary concerns and help strengthen the Dollar. Although the Federal Reserve left rates unchanged at the latest meeting, it has thus far not expressed any intention to commence another round of quantitative easing, although maturing bond purchases will occur on a more limited basis.

Finally, a weak Dollar isn’t necessarily welcomed by the rest of the world, contrary to popular belief. For US trade partners with a large export sector, such as Germany and Japan, a low US Dollar is detrimental because that means lower levels of trade with the US and effectively puts a cap on future growth. A number of currencies, including all of the other currencies that make up the US Dollar Index, have appreciated against the Dollar. Therefore, it is possible the foreign central banks could increase their Dollar purchases in the name of slowing their own currency’s appreciation. This would help stabilize the Dollar, and perhaps even contribute to a medium-term rally.

Looking at the technical analysis, indicators are signaling, as they were in March, that the Dollar could be at or near a medium-term bottom. Looking at long-term charts, despite the Dollar’s pronounced downtrend over the past decade, it could potentially be setting up for a break to the upside. While the Dollar has dropped, the Moving Average Convergence-Divergence (MACD) has been rising. A positive divergence while the Dollar is in a downtrend could signal a pending reversal to the upside. This is also true of the short-term charts, as you can see from Chart 1. Looking at a chart of the Dollar over the past year, the charts are also showing divergence in the Relative Strength Index (RSI), which, despite the continuing drop in the Dollar, has failed to make significant new lows, instead floating around its previous lows (Refer to Chart 2). Such a divergence/chart pattern often precedes a reversal, in this case to the upside.

Therefore, with the robust upturn in the Dollar over the past week, the medium-term bottom may very well have been made. While all fiat currencies, at least amongst Western economies, will continue to be under pressure as currencies are devalued, for now the Dollar appears to be commencing a medium-term rally.

Respectfully Yours,

Matthew R. Green

May 8, 2011

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