Changing My Stance on the Dollar

by Louis Basenese

Investing requires tough decisions. What to buy? When to buy? How much?

But none more difficult than this: Admitting the fundamentals no longer support an investment you own. Or, as the French philosopher Geoffrey F. Abert summed it up over 900 years ago, “It often takes more courage to change one’s opinion than to stick to it.”

And today I’m living proof.

Just three weeks ago, to the day, I declared, “The dollar’s not done.” I laid out my case about Jim Rogers being wrong.

But I’m officially changing my stance on the falling U.S. dollar.

To be clear, it’s not because I finally saw the light, recognized the error of my ways, or heeded the “sage” advice of so many of you that wrote in to chastise my “foolishness” or “ignorance.” And I didn’t get a personal phone call from Jim Rogers, either.

I don’t cave to bullying or criticism. Just fundamentals. And the bottom line is this - for most of the year, the fundamentals supported a stronger dollar. Enough so to allow my subscribers to lock in gains shorting the euro versus the dollar of 12%, 58%, 60%, even 267%.

But those fundamentals changed. Big time. So here’s what you need to know, and how this fundamental change could be as profitable as the last one.

U.S. Dollar Doubts Surface As Investors Give Up On Yield & Value

My first doubts about the U.S. dollar surfaced when investors gave up on yield and value. In return for, well, no return. Remember, last week I reported demand for four-week Treasury bills - offering ZERO percent interest - outstripped supply four times over.

If that wasn’t bad enough, I noticed investors on the long-end of the bond market weren’t investing any smarter. All they want is “safety-only,” too. Case in point - the yield on 10-year and 30-year Treasuries fell below 3%.

Forget below average. Such paltry yields represent the lowest levels in the last 50 years.

So what’s the big deal? Well, it’s the equivalent of Bank of America (BAC) putting out a curbside sign during the real estate run-up advertising “no-documentation 1% mortgages.” People can’t resist cheap money. And we shouldn’t expect our elected representatives to show any better restraint. They will borrow cheaply and spend freely, while they can.

And it’s the extent of this spending that troubles me, and threatens the dollar the most.

The Flood is Coming and There’s No Ark to Save The Dollar

Forget the $530 billion of government debt that flooded the market last quarter. Or the $550 billion estimated for this quarter. President-elect Obama is planning a tsunami.

If you have any doubt, just consider the trend in estimates for his soon-to-be released economic stimulus package.

• A few weeks ago, $500 billion was the consensus number.
• Then it crept up to $700 billion.
• Now, Republicans and Democrats alike believe the final plan will top $1 trillion.
• And that’s on top of the $4 trillion price tag for his proposed middle-class tax cut and universal health care.

The only way to absorb the impending and massive Treasury issuances will be for the Fed to flood the market with dollars. Or put more plainly, to run the printing presses 24/7 - which many of you already suspect they’re doing.

Arguably, these factors alone should be enough. But I’m stubborn. I wanted one more thing before I let go of my dollar bullishness. And Tuesday I got it.

The U.S. Dollar Index Breaks An Uptrend

Recall, in July the U.S. dollar index bottomed out and entered a confirmed uptrend. But after rattling off about a 20% gain, everything just came unglued. And Tuesday, the U.S. dollar index officially broke through the uptrend line. So look out below. Because there’s no telling where the next support level rests.

That being said, I don’t think it’s time to do the opposite of my previous recommendation, and get long the euro. Not hardly. The recent hawkish comments out of the European Central Bank scare me. They won’t be able to escape this financial crisis either, no matter how defiant the rhetoric. Plus, euro-zone banks still need to unwind as much as $800 billion of dollar-denominated leverage.

In short, the upside in the euro versus the dollar will be subdued. Not to mention, a far better opportunity exists shorting long-dated Treasuries.

As The Bond Market See-Saws…

The bond market is remarkably simple - it’s a seesaw, with interest rates on one end & bond prices on the other. When one goes up, the other goes down.

If you have any doubt, consider recent history. As the Fed aggressively cut interest rates, bond prices went vertical. Up 20% in some cases. That’s unheard of for bonds. And it represents our newest bubble (first real estate, then oil, now treasuries).

Make no mistake, this bubble will end just the same.

• First, because the government can’t get away with near zero yields forever. Investors will eventually demand a respectable return on their money. Especially foreign governments. In the last quarter alone they increased their U.S. debt holdings by 12%, according to Bloomberg. To load up even more will require additional compensation.
• Second, because inflation is around the corner. Never has a world government spent (or planned to spend) so much and avoided it. The only way to curb the resulting inflation will be for the Fed to abruptly reverse course, and begin raising rates at the first signs of an economic recovery.
• Bottom line, the only way for rates to go from here is up, which means bond prices will head in the opposite direction.

Again, I aim to be transparent in my analysis. Always. And that includes defying Lillian Hellman’s observation that “people change and forget to tell each other.”

Consider this your notice. My outlook for the falling U.S. dollar has changed, albeit quickly.

This isn’t an apology. It’s simply a heads-up that more compelling opportunities exist. One fellow colleague summed up perfectly, “If you don’t short Treasuries right now, you’re dumber than investors buying them for a zero percent return.”

A bit harsh. But hard to refute.

Comments

[freefall51:]

A lot of money was flowing into TBT yesterday morning trending up slightly and out of TLT. TLT seems to trade inversely to $SPX at his time. If $SPX tops out TLT would bottom and go higher from there causing another drop for TBT.

What worries me is the threat that the Feds may buy up their own longterm treasuries to keep the interest down and prices up. They are reckless enough to do that.

The bearish $ bet UDN seems to be a better deal at the moment. You have the Feds on your side.

2008 Dec 18 08:41 AM

[CurveTrader:]

Good Points. I absolutely agree with you on Treasuries, although timing is critial, as bubbles can continue longer than you can stay solvent. Regarding the dollar, there are several points that make me think that this is simply a correction in the uptrend- and a bear market rally for the Euro. Firstly, rate differentials will fade next year as more and more central banks are forced to cut their rates to zero. In Europe, Germany will not be able to hold up the region and the currency, as countries such as Spain, Italy and Greece are already in big trouble. Secondly, this is a global recession and the wolrd's major export countries, Japan and Germany, will not come out of it if their currencies go through the roof. At some point central banks will intervene. Thirdly, commodity prices have not risen along with the declining dollar and gold has not broken major trendlines, weakening the argument of a trend change for the dollar. I simply cannot see inflation on the rise any time soon. The Fed might try to reflate the economy, but in a country that is deleveraging and is already loaded with debt, that will take a long time. Furthermore, the deleveraging of hedge funds may be over for now but probably will come back in Q1 as new redemptions set in. From an intermarket perspective, a trend change in the dollar would imply a trend change in commodities and equities which I can't see. Commodity, equity and real estate prices will probably continue to fall next year, causing deflation. Finally, major trend changes are normally not signaled by spikes (see Euro chart) on low volume, which are more the result of short covering rallies. So, you are correct on the trendline breaks, but I think one has to be cautious and move to the sidelines first and watch how the dollar moves at the beginning of the next year when volume comes back. I absolutely agree with you not to go long any of these currencies against the dollar now, but rather watch the bubble in Treasuries to burst in the next three months and open short positions.

2008 Dec 18 08:41 AM

[Asbytec:]

User, right on.

The dollar is in trouble, there is no doubt. But, these are volatile times. What we witnessed was volatility...panic, fear, something. The Fed rate cut certainly spurred the markets for a day, but they will return (or already have returned) to their volatile ways. Risk appetite gives way to aversion and back again. Both give way to yield which may give way to more panic(?) when the EU cuts rates.

It is telling commodity prices remain relatively flat despite the dollar's plunge. (I said relatively.) The drastic measures the Fed is taking are also telling. The global economy is in more trouble than those politely worded central bank statements will attest to. "Downside risk," my back side! Yaaaaa betcha!

2008 Dec 18 09:58 AM

[Dean M:]

Your thesis is plausable but that chart for tbt seems to define a falling knife. Maybe it's better to wait for a breakout..

2008 Dec 18 10:31 AM

[OldLimey:]

Where is it written that the USD and commodities MUST move inversely? Just because it has happened in the past does not mean it has to happen now. Personally, I am bearish on both the USD and, for the time being, most commodities (certainly non-precious metals). Am I the only one to hold this view?

Regarding what the ECB will and will not do, I have no more idea than anybody else on SA. However, North American readers need to keep in mind the entirely different folk and institutional memories that our continents have. The US obsession with the Great Depression and deflation is not matched in a Germany obsessed with the threat of hyperinflation. And one thing I can say with certainty: the excesses of Spanish property developers is not going to bounce the Germans into toying with the sort of inflation the Fed seems bent on rekindling in order to whittle away America's debt overhang.

2008 Dec 18 10:37 AM

[Asbytec:]

Limey, good point. I really have no idea either, just a (pseudo) educated guess.

I understand the ECB mandate and their course of action. In fact, I was hoping the Fed would not sink rates to zero. Aggressive rate cuts have not helped move credit markets. And I'd understand if the ECB held steady, too. There is plenty of liquidity, just not enough lending. I'm a proponent of the liquidity trap theory.

But, I guess it depends on the ECB stance on price stability. Does such a stance include falling prices? I am sure you'd agree our banking system is designed to function under inflation. And, that's the point, in my view. Will falling prices lead to foreclosures and other (possible) deflationary evils in Europe?

I am betting the ECB will get on the deflation train, albeit hawkishly because of the hyperinflation threat as you point out. However, they may have to induce some inflation. Besides, this coordinated (and presumably agreed upon) effort is well understood on both sides of the Atlantic. That's the basis of my call on EU rates.

As for gold, well, man...that's anyone's call at this point. Yes, it's gone up a bit. But, there are growing arguments to sell, and they are deflation based arguments.

2008 Dec 18 11:01 AM

[raytayzmd:]

...short term looks bearish but long term charts suggest a possible reversal starting earlier this year:

www.fxstreet.com/rates.../

...I wouldn't be inclined to trade contrary to that unless I saw some confirmation in new lows.

2008 Dec 18 11:22 AM

[HiSpeed:]

I respect a guy who arrives at a new conclusion when new information is presented.

That said, the market can remain irrational longer than some traders can remain solvent.

All bubbles end the same; this will be no different.

2008 Dec 18 11:45 AM

[Alex Trias:]

Here's the thing about periods of risk aversion: it's candy for the government. The Treasury is selling Treasuries and buying unwanted corporate debt, and pocketing an almost historic spread. My hunch is that probably has been highly supportive of the dollar insofar as the dollar is basically stock in the US government which, at the moment, is poised to make a killing by arbitraging current risk aversion in the credit markets. Maybe it's no coincidence the dollar rallied back in the summer, when risk aversion in the credit market was hitting an all time high?

And another thing. The value of the dollar is relative to the value of other currencies. Supply has something to do with this. What I'm saying is that other governments get to do what the US government is doing, and make lots of money in the process. They're doing it, and will continue to do it. My guess is we'll see Euros and Yens flooding the marketplace too, along with torrents of dollars.

Fundamentals aside, the real issue is how easy it is to trade the buck against other currencies. At the moment, the dollar is poised at it's 200 day moving average. If this area acts as support, fantastic. The dollar will rally a bit in the short term and, maybe, the long term. If not, and the dollar slices through technical trading support, then that will be the shortest long term upward price trend the dollar's ever seen.

2008 Dec 18 12:01 PM

[Chris B:]

It seems like all the world's big money is betting on deflation - that's what it would take to drive yields this low. Yet, as a depression scholar, "helicopter" Ben Bernake seems like the perfect person at the perfect time to know what to do in order to defeat it - flood the market with unheard-of liquidity. He's been cutting rates since August 2007, even through the 5%+ inflation we had as recently as June '08, supporting asset purchase legislation and "tax rebate" checks to consumers, and buying trillions of dollars in bonds. No viable political party opposes even further "stimulus." Furthermore, as the world's largest debtor, inflation is clearly in the government's interest. When energy costs rebound in the next few months, all this deflation talk will be over with, and as the author points out treasuries bought at prices yielding near 0% will plummet. To doubt that governments can engineer inflation when that's what they want to do is utterly foolish - unless you're just speculating on further dollar appreciation vs. your home currency.

When the whip cracks on the treasury bubble, it's not clear what all of the side effects will be.

Will higher rates support higher values for the dollar?

Will and effective refinancing of government debt leave the costs of servicing that debt lower, thus improving US creditworthiness?

Will the crash in the value of treasuries prop up suffering regional currencies?

2008 Dec 18 12:12 PM

[LilBob:]

I mostly agree with Alex. But I disagree with the consensus that we need a strong dollar. Sure, a strong dollar makes for prestige and it makes those goods in our NAFTA partner countries that much cheaper, but I'd like to see a return to small scale specialty manufacturing because the consumer based economy is essentially over. Holding onto a strong dollar mentality is a bad idea right now. Cheap dollars make our debt payments to China that much cheaper, and it also makes US made goods more price competitive with other countries. To me a desire for a strong dollar is nonsensical.


On Dec 18 12:01 PM alex trias wrote:

> Here's the thing about periods of risk aversion: it's candy for the
> government. The Treasury is selling Treasuries and buying unwanted
> corporate debt, and pocketing an almost historic spread. My hunch
> is that probably has been highly supportive of the dollar insofar
> as the dollar is basically stock in the US government which, at the
> moment, is poised to make a killing by arbitraging current risk aversion
> in the credit markets. Maybe it's no coincidence the dollar rallied
> back in the summer, when risk aversion in the credit market was hitting
> an all time high?
>
> And another thing. The value of the dollar is relative to the value
> of other currencies. Supply has something to do with this. What I'm
> saying is that other governments get to do what the US government
> is doing, and make lots of money in the process. They're doing it,
> and will continue to do it. My guess is we'll see Euros and Yens
> flooding the marketplace too, along with torrents of dollars. <br/>
>
> Fundamentals aside, the real issue is how easy it is to trade the
> buck against other currencies. At the moment, the dollar is poised
> at it's 200 day moving average. If this area acts as support, fantastic.
> The dollar will rally a bit in the short term and, maybe, the long
> term. If not, and the dollar slices through technical trading support,
> then that will be the shortest long term upward price trend the dollar's
> ever seen.
>

2008 Dec 18 08:23 PM

[Asbytec:]

Okay, back to fundamentals. Inflation is a monetary phenomenon, right? If you can buy a home for $1 today and sell it for $2 tomorrow, it is probably due to the value of the dollar falling by half (demand driven prices aside for now.)

Now, this sounds like a great investment, double your money in a day. We tend to hold the value of a dollar steady in our mind and valuate asset prices around that "pegged" and undefinable value. Assets, such as homes, look more valuable. So in reality, demand driven prices aside, the seller may have more dollars except each has at less value.

This is inflation and it cause folks to borrow money on hopes asset prices will rise...which looks like wealth. He or she might feel richer by saying they have twice as many dollars as before.

Well, deflation is the opposite. If prices are falling, well, no one want's to lose the number of dollars they have. No one wants to buy a house at $2 today and sell it for $1 tomorrow despite the real value of the currency...which makes the home more expensive, really. And banks certainly won't loan anyone the money to default on such a deal.

But, in this case, the currency is getting stronger. The "real" value of the home hasn't really changed much, provided supply or demand haven't driven the price. The home still has 2 bedrooms, 2 baths, and a view. Nothing has changed. The asset is still there.

So, in deflation, one is actually better off if holding dollars and not in debt...or has the rare courage to stick with it during deflation. Our paychecks have benefited from decades of keeping pace with inflation and our level of money should be pretty good. So, we have more money at a higher value, each dollar.

This is a form of wealth, as opposed to illiquid borrowing someone else's money on that second mortgage.

So, we say we're in a deflationary spiral. Well, I guess the threat is certainly real. So, if the dollar is becoming more valuable despite the efforts to fight deflation, then why not hold it and pray for a bit more? Just a bit more, be thankful. Hold onto that home, refinance if at all possible.

Well, that is, hope for more deflation until the economy totally collapses because the credit markets completely freeze solid. They will, they have, because in our system...money is debt, not wealth. But, while deflation lasts, it is wealth. And someone doesn't like that.

But, I'm not sold on the deflationary spiral just, yet. Once the first of the sub prime mortgages began to fail, home prices (pseudo values) were driven down by supply and demand, not deflation. However, with oil prices and it seems other commodities pretty much flat, maybe we are on the verge of deflation...which means a stronger currency relative to assets.

Yes, stronger currencies through the world, except Zimbabwe, of course...and strength measured relative to each other.

The Fed created a mini rally on Fed day and killed the dollar against the euro and yen...and the Aussie, and every other major. They did not succeed in halting market volatility or currency volatility. What we saw in the dollar was a volatile reaction.

But, other nations (developed and emerging) should be undergoing the same deflationary cycle and credit squeeze we are to varying degrees of severity. They have to act or face ruin, and the euro zone is pretty much down that path as we are. They are debt based currencies, too, just like the dollar. They thrive on debt creation (of money) and inflation.

The ECB has the mandate of price control. Fine. Deflation is a price concern, just like inflation, only for very different reasons and in the opposite direction. So, if the ECB will not hesitate to fight inflation through tightening, they should be willing to fight deflation through easing, albeit hawkishly.

Again, what we saw in the dollar (and the markets) I suspect was a volatile reaction to Fed rate cuts. They scared the proverbial poo out of everyone, including me. The dollar index might support that claim of volatility and future strength. Future rate cuts by central banks lagging the US will bear this out. We live in volatile times, expect volatility.

But, as I've argued, deflation is supporting (or will support) the dollar. If deflation is among us, it should become more valuable as other central banks race to inflate. Is that fundamental enough? :-P

2008 Dec 18 10:25 PM

[Asbytec:]

Well, seems Japanese and EU "easing" have breathed new life into the dollar. Also, a recent check of the index indicated the Bush Big 2 Bail out did likewise. More to come, I guess...

2008 Dec 19 11:18 AM