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.