The US Dollar Bear 2
Adam Hamilton November 14, 2003 3314 Words
With the latest reported record-high US trade deficit, a whopping $41b+ in September alone, the US dollar is once again back in the limelight. At this enormous trade deficit’s current run rate, it will push an astounding $500b by the end of 2003, utterly crushing last year’s record of $418b during all of 2002!
Naturally the insatiable American demand for imported goods and even services dramatically impacts the global supply and demand dynamics of the US dollar. We Americans pay for our imported goods in dollars, flooding the world with Federal Reserve paper, which is then sooner or later spent elsewhere by the original exporting countries.
As these exporting countries trade the dollars that American consumers indirectly paid them for other goods and services that these countries need to grow, the total supply of dollars outside the United States continually increases. This helps drive down the price of the US dollar in the massive international currency markets. An increasing global dollar supply against the backdrop of relatively stable global demand leads to lower dollar prices.
While only one factor among many that affect the dollar, the gaping US trade deficit reported this week offers a great opportunity to reexamine the current state of decay of the bear market unfolding in the world’s reserve currency.
Back in early April when I wrote the original “The US Dollar Bear”, the war-rally euphoria was deafening and Wall Street predicted a strong recovery in the world’s most widely used fiat-paper currency. While considered heretical at the time, many contrarians including I were predicting a primary bear market in the US dollar, a milestone which had yet to be officially crossed in April.
From its early July 2001 top near 121, the venerable US Dollar Index had to fall 20% over a period of one year or more to officially enter bear-market territory. The line in the sand before this No Man’s Land of bear-marketdom was drawn at a US Dollar Index level of 96.7. While we were precariously hovering right on the verge of this bear-market abyss in early April, by May the mighty dollar finally cracked below 96.7 on a closing basis and the US dollar bear market was born.
The ultimate implications of this now indisputable US dollar bear, especially for Americans, are probably even more profound and important than even the unfolding Great Bear in the US stock markets. The US dollar is the linchpin that connects together all commerce in the States, and much in the world, from the tiniest transaction between two individuals to the largest deals between multi-national corporations. Changes in the international price of the US dollar ultimately impact the vast majority of world commerce today.
As this week’s essay is intended to be an update on the current state of the US dollar bear market, I am going to attempt to limit my discussion primarily to the dollar events of 2003. If you would like more strategic background information on the US dollar bear running back several years, you may wish to skim my original essay on this subject.
Our graphs this week are also updates from this earlier essay as well. While my analytical focus remains on the US dollar action of 2003, we decided to run our graphs back to 2001 in order to help keep this year’s fascinating dollar developments in their proper strategic perspective. The dollar’s behavior relative to the S&P 500, real interest rates, and gold is quite illuminating and offers tremendous insight for investors.
While not generally widely discussed, the US stock markets and US dollar usually have a strong positive correlation. When the US markets are soaring and euphoria abounds, foreign investors around the world start selling their local currencies and buying dollars in order to invest and speculate in US equities. This increased marginal dollar demand drives up the global dollar price.
Conversely when the US markets are languishing foreign investors typically grow cautious and sell some of their US stock positions and repatriate their capital back into their local currencies, driving down global dollar prices. As such, the US dollar’s price on the world markets generally tracks the fortunes of the US stock markets fairly well. This strong relationship is illustrated below with the US Dollar Index superimposed over the flagship US S&P 500 stock index.
In general over the past few years, the US dollar has indeed empathized quite well with US stocks, rallying when the S&P 500 rallies and plunging when the S&P 500 plunges. Prior to the end of Q1 2003, this relationship dominates the chart, and is quite logical for the reasons explained above. But, beginning shortly after Washington’s annexation of Iraq in late March, this old US dollar/equity relationship has gone seriously haywire in 2003. The S&P 500 has soared while the US dollar has sputtered!
Early in this year’s spectacular war rally, throughout much of Q2, the S&P 500 rocketed higher while the US Dollar Index plunged like a millstone. Somewhat paradoxically, the dollar carved an interim bottom just above 92 in mid-June within days of the initial S&P 500 interim top around 1012 in the war rally in US equities. Then the dollar suddenly reversed and marched relentlessly higher in a strong countertrend rally that carried it all the way back up above its 200-day moving average.
During this countertrend rally the dollar managed to blast up by 7.5% in less than three months, which is really a fast move for the world’s most important currency. Interestingly though, while the dollar was rallying last summer the US stock markets essentially just ground sideways, with an unimpressive 3.4% gain in the S&P 500 during the dollar’s largest bear-market rally in years.
Then, just as the dollar’s bear rally was collapsing in early September, the US stock markets managed to fight heavy valuation headwinds and claw their way back up to fresh new interim highs in recent weeks. The dollar celebrated the good fortunes in equity-land by collapsing down to fresh new-bear-to-date lows around 91 in late October. This odd dollar behavior contrary to the prevailing short-term trends in the US stock markets is quite anomalous and very worthy of consideration.
One potential interpretation of this puzzling data is that foreign investors, for some reason, largely chose not to play this latest bear-market rally in the US stock markets. A falling dollar, like any free-market commodity, reflects relatively lower dollar demand chasing relatively higher dollar supply. Each dollar is worth less in this scenario. If global dollar demand was lower and/or global dollar supply was higher, then foreign investors for the most part were probably not buying dollars to enter the US equity markets, but instead on the net were still selling their US dollars for much of 2003.
It is always challenging trying to assign causes to the effects that we can observe in the markets, but nevertheless contrarian analysis demands that we undertake this very speculative exercise. Why would foreign investors, facing the largest rally in US equities since the Great Bear began a few years ago, apparently remain largely on the sidelines and out of the party?
One potential reason is the US Federal Reserve’s current foolish policy of maintaining an openly hostile posture towards savers and investors. Pandering to heavily indebted US consumers, the Fed is systematically destroying the delicate and necessary free-market balance between savers and debtors. Both savers and debtors, like any two parties engaging in a voluntary transaction, should find their transactions to be mutually beneficial.
Savers should earn a fair return on their scarce capital and debtors should pay a fair price for the privilege of using capital that someone else had the discipline and foresight to save. When one side is forced to pay or accept a price way out of whack with what the free markets would set if unmolested, gradually the capital markets freeze up. If capital transactions are not mutually beneficial, the side getting robbed, in this case the savers, gradually decides to quit investing since they cannot earn a fair return on their scarce capital.
Raw capital, or US dollars, is priced in terms of interest rates. If you manage to consume less than you earn and accumulate a surplus of capital, you are rewarded by earning an interest rate for lending your saved money. If you consume more than you earn like the majority of folks these days, you are offered an opportunity to finance your deficit by paying an interest rate to a saver.
As each subsequent month passes by, I am growing more convinced that the horribly biased pro-debt interest-rate policies of the US Fed are contributing heavily to the dollar’s persistent weakness even in the face of a mighty rally in US stocks. Foreign investors, or savers, may want to invest in the US, but they are faced with an unattractive choice between chronically overvalued and extremely dangerous stock markets or bond markets sporting trivial yields not worth the risks involved. Foreign investors are being robbed everyday to subsidize American debtors, and the foreigners naturally don’t appreciate this.
Indeed, after inflation today any investor owning US Treasury debt maturing in a couple years or less will actually lose capital by purchasing bonds. The rate of inflation, the Fed’s relentless debasement of the US dollar, is far higher today than the interest rate that can be earned in the marketplace. Any investor, either American or foreign, is guaranteed to lose real purchasing power today if they buy shorter-term US Treasury debt instruments that mature in the next couple years or so. The Fed has dangerously made investing saved capital an unacceptable no-win proposition for savers.
The nominal interest rate that we can earn in the markets today less the rate of inflation is known as the real interest rate. I have discussed real interest rates in depth in my “Real Rates and Gold” series of essays if you are not familiar with this crucial concept. The high positive correlation between the US Dollar Index and real interest rates, even in 2003, is amazingly powerful and quite revealing.
Only a couple years ago, foreign investors could buy dollars to invest in the US capital markets and earn 1% to 1.5% a year in the bond markets after inflation. 1% or so isn’t a lot and is nothing to write home about, but it is something. A positive real return in the stable and safe United States is attractive to a lot of foreign investors. During recent times of relatively high real rates, global demand for US dollars increased and the US Dollar Index price marched higher right along with it.
Once Greenspan and the Fed declared open war on savers though, both real rates of return and the US dollar started to plummet rapidly. Even in 2003, when the US dollar was not correlating well with the stock markets, it did maintain an excellent correlation with real interest rates. This suggests that real rates may indeed be the key to understanding the dollar’s accelerating bear market.
When negative real rates were rising, offering some sliver of hope to foreign investors that the Fed would stop trying to rob them to subsidize out-of-control American debtors, the US dollar generally rose as well. Conversely when negative real rates were falling even lower yet, the US dollar’s bear trend generally resumed. The fortunes of the US dollar have been closely tied with the real rates of return available in US Treasuries with a one-year maturity.
Until the Fed quits bullying around short-term interest rates in the US and allows them to rise to a fair free-market level where both savers and debtors can engage in mutually-beneficial capital transactions, the US dollar bear will likely continue. The longer that real rates remain negative, the more long-term damage will be done to the US dollar and the longer it will take for foreign investors to ultimately regain confidence in the US financial system.
I doubt that the US dollar bear will even consider ending until real rates in the US go massively positive for as long is as necessary to convince foreign investors that the Greenspan madness is over. It is a big world out there and it makes no sense investing in US dollars in a bear market for negative real returns when other first-world industrial powers are paying 4% to 5% short-term rates to investors for their scarce capital.
Different countries around the world directly compete for investors’ hard-earned capital, and the mighty US is no exception. While countries like Australia and England are now actually raising their short-term interest rates in an attempt to rein in their own local speculative bubbles in consumer debt and residential real-estate, the gaping differential between returns available in the US dollar and other major currencies is ballooning rapidly.
As more and more other nations raise rates while the US Fed continues foolishly forcing investors to subsidize debtors, demand for the US dollar will continue to fall along with the dollar’s value, prestige, and status in the global marketplace. Positive real rates in the US again, while nowhere in sight now, will probably be among the earliest major signs that the US dollar bear is nearing the end of its long and painful run.
One final note on the dollar and real rates, which I find really intriguing. At the end of Q1 2003 above you can see a huge vertical spike in the light-blue real-rate line. After this massive increase in real rates one would think that foreign investors would have increased their dollar buying based on their past behavior. This time, however, they completely ignored the large real-rate spike and the dollar continued to plunge. Why?
As I have discussed extensively in my past real-rates essays, real interest rates are computed by subtracting the annual change in the US Consumer Price Index from the rate of return on 1-year US Treasury Bills. While T-Bill yields are more or less set in the free-markets, although heavily influenced by Fed manipulation of the short end of the yield curve, the CPI is just a pure government fantasy, political fiction.
Every year Americans’ crucial actual costs of living are skyrocketing in reality, but every year the government lies about it and intentionally lowballs the CPI for political and fiscal reasons.
Many enormous Welfare State expenses, like the pensions and benefits the US government uses to bribe voters, are indexed to the CPI. If the CPI can be artificially lowered, then the federal government in Washington can spend less on pensions and more on discretionary pet projects that the politicians love, like waging endless foreign wars and eviscerating American Constitutional freedoms. There is a huge incentive for the US government to lie about the real level of consumer inflation ravaging Americans today.
The entire massive leap in real rates at the end of Q1 on the chart above is due to the US government’s own CPI report alone. It is fascinating to me that the dollar did not react to this rise in real rates at all, quite possibly because foreign investors realize that the CPI is just a bunch of smoke and mirrors anyway, pure political hooey. Real-world Treasury yields didn’t actually rise, Washington just claimed that inflation had miraculously crashed, so real rates soared. How convenient!
The immense international currency markets, however, were not fooled. They apparently realized that real interest rates in the US could not miraculously change overnight just because some federal lackeys used statistical wizardry to falsely report plunging inflation to please their political masters. It is always wonderful and exciting to see real-world examples of free markets not being swayed by government propaganda and lies!
Since the Greenspan Fed insists on robbing savers to feed out-of-control debtor speculative excesses, the US dollar is doomed to grind lower until this madness ends. As the dollar falls, the primary beneficiary of its bear market is the Ancient Metal of Kings. Gold has always been the ultimate currency, a timeless rare metal with unquestionable intrinsic worth. Gold, which is not merely someone else’s hollow promise to pay later like paper currency, rises in value as paper currencies like the US dollar fall.
Not surprisingly the mighty Great Bull market in gold began right around the dollar’s long-term top in 2001. Gold’s awesome early ascent of the past few years has been scoffed at relentlessly by the mainstream Wall Street crowd, yet us early contrarians are already being blessed with rapidly multiplying riches by riding this exciting young bull market in gold.
Gold is the natural and historical alternative to paper currencies and paper investments when governments choose to foolishly force real rates of return negative and dismantle fair free-market capital transactions between savers and debtors. Why invest in depreciating dollars for a guaranteed loss in purchasing power of at least 1% a year when you can invest in a true currency that has easily weathered six millennia of human history?
This compelling logic is not lost on foreign investors, who are often much less biased against gold than we in America have been trained to be. Gold investment has long been recognized and respected around the world. Most other countries have been ravaged by huge inflations and less-than-peaceful government transitions in modern history, so they rightfully have a much lower trust level in pure paper currency, a government fiction, than us complacent Americans.
Just as the US dollar bear will almost certainly persist as long as US real interest rates remain negative, so will the bull market in gold. This week’s exciting challenge of US$400 in gold is just the beginning. Currency and interest-rate trends are massive and tend to run for 5 to 7 years or more, so odds are the Great Gold bull is just getting started.
If you are concerned about the dollar bear market, spiraling inflation, and your rapidly eroding purchasing power, gold is the place to be if you are an American investor. As history has shown, the gains in gold will far outstrip both the depredation of the Fed’s inflation and its naked debasement of the US dollar. While a US dollar bear can be devastating for stocks and bonds, gold will shine brightly and remain a refuge and pillar of strength through these turbulent financial times.
At Zeal we have been bearish on the US dollar and bullish on gold for the entire major trends unfolding in these two competing currencies. We have been blessed with great realized gains so far trading gold and silver stocks, but I believe that the best is still yet to come. The greatest years in any gold bull, and the worst years in any dollar bear, are the final years before the end. Since we are still early in both young trends we probably have not yet witnessed the Really Big Moves.
If you want to avoid the carnage from the US dollar bear, and have a shot at earning legendary profits in the Great Bull in gold at the same time, please consider subscribing to our acclaimed Zeal Intelligence newsletter. In this monthly letter I continue to offer real-world strategies, practical insights, and actual trades for avoiding the dollar and equity woes in the US and profiting in the strengthening commodities bull. Join us today!
The average 5 to 7 year lifespan of a US dollar bear means that we are potentially looking at ugly dollar bear conditions until 2007 or so, a lot of time left yet. While the Fed’s asinine negative real-rate policy continues to destroy the US dollar and feed the growing gold bull, you may as well profit from this mess, not to mention protect your scarce capital from the accelerating losses in dollar purchasing power.
As King Solomon wisely said millennia ago, “The prudent see danger and take refuge, but the simple keep going and suffer for it.”
Adam Hamilton, CPA November 14, 2003 Subscribe at www.zealllc.com/subscribe.htm