In 2003, the NBA welcomed LeBron James - the new king of basketball. Everybody laughed at the time as the king still had no clothes. Over many years of trials and tribulations, the king learned and improved, diligently honing his game, becoming more skilled and efficient and now he has finally arrived, in full control of his power, to lord over the league. King Dollar (NYSEARCA:UUP) has had a similar journey since 2003. Starting with the implementation of Keynesian economics under President Bush, the US dollar index fell from the 105 level down to a bottom of 72 in 2008 as the US was struggling in the middle of the financial crisis and fighting two unjustified wars. But surprisingly since the implementation of multiple quantitative easing programs under Ben Bernanke, the dollar hasn't fallen any further. It has in fact bottomed and consolidated very nicely over the past 5 years and is poised for a strong comeback with the amazing improvement in US corporate efficiency, the prospects of an explosion in domestically produced energy and a return of supply-side economics (via corporate tax reform). Let's look at some macroeconomic factors that will fuel the rise of the US dollar in 2013.
Composition of the US Dollar Index
The U.S. Dollar Index (USDX) is a geometrically-averaged calculation of six currencies weighted against the U.S. dollar. The U.S. Dollar Index was created by the U.S. Federal Reserve in 1973. Following the ending of the 1944 Bretton Woods agreement, which had established a system of fixed exchange rates, the U.S. Federal Reserve Bank began the calculation of the U.S. Dollar Index to provide an external bilateral trade-weighted average of the U.S. dollar as it freely floated against global currencies.
The first thing to note is that not all currencies that participate in the calculation of the index have the same weight. In fact, some currencies are much more important than others. What is the weight of each currency in the index?
Source: Intercontinental Exchange
The Euro (NYSEARCA:FXE) accounts for nearly 60% of the US dollar index, the Japanese Yen (NYSEARCA:FXY) a paltry 14% and the British Pound (NYSEARCA:FXB) at 12%. The Euro is 4 times more important than the Yen and 5 times more important than the pound. A 10 basis point move in the euro can wipe out a 40 basis point move in the yen and a 50 basis point move in the pound. While the US dollar has gained strength recently against the yen and the pound, what would really fuel a permanent rise in the dollar is a significant decline in the value of the euro. I think a tectonic shift in European monetary policy is coming in 2013 that would lead to a permanently weak euro for years to come. Let's explore the reasons
Significant Divergence Exists Between the US and Euro Zone Economies
While the financial media tends to focus on Treasury, Bund and Gilt spreads, I like to look at economic indicator spreads. The US-Euro Zone spreads for major economic indicators such as Purchasing Manager Indexes (PMI), Consumer Confidence, Unemployment Rate, Consumer Price Indexes (CPI), Exports, etc, can give you a strong sense of the significant divergence that exists between the performances of the US and Euro Zone economies since the start of 2012:
The spread between the PMI index spreads hasn't fallen below 4 for both services and manufacturing. Keep in mind that the service sector is 70% of the economy in both the US and Europe and the US outperformance there is even more pronounced with spreads bottoming at 6. While the US indexes post very strong above 50 readings, Europe is stuck with below 50 readings (signifying recession) at very low levels. The unemployment spread is astounding. This is indicative of many more unemployed Europeans than Americans and the divide is getting bigger every month. This, not surprisingly, filters down to consumer confidence which hasn't had a positive reading in Europe in quite some time. Weak consumer confidence leads to weak retail sales and that usually leads to further contraction in the economy. To add insult to injury, the export sector usually one of the brightest points in the European economy is rapidly being overtaken by the United States export sector closing any current account gap between the two economies. On the inflation front it is clear that Europe is struggling with deflation while the US is growing prices at a very healthy pace, boosting corporate profits and employment. While the US looks poised to pull away in 2013, Europe is sinking further into recession.
Today's flash PMI from Europe painted an even grimmer picture. Euro PMI Manufacturing and Services fell to 46.6 for March contracting faster than prior months. German PMI Manufacturing registered a 48.9 reading (well below expansion), and PMI Services collapsed to 51.6 from 55.7 in January. Even Germany, the best house in the poor neighborhood that is Europe is starting to crumble and we're not even in the middle of the summer months yet.
The Meaning of Cyprus
Europe is in such a bad financial and economic shape that it can't cobble together a coalition of countries to fund $20 billion to rescue a couple of banks in tiny Cyprus. Warren Buffet can pony up the cash himself and still have another $30 billion to buy himself a nice banjo. The Cyprus situation is indicative of a new European order. While bailouts in 2010, 2011 and 2012 featured Merkel and Sarkozy coming in as white knights to rescue Ireland, Greece, Portugal and Spain, one part of the Franco-German alliance is now glaringly missing in 2013. France is mired in a collapsing economy similar to the US in 2008. The French PMI Services index registered a flash reading of 41.9 in March, contracting faster. A level of 37-38 is usually the absolute lowest reading you will ever see in a PMI index. France is very close to that. Things are bad and getting worse. Germany, the second half of the European bailout crew, is in an election year and the governing party has little appetite for the unpopular bailouts. Not that the German economy is going gangbusters or anything, Germany has its own problems as well. That leaves Europe without a savoir in 2013. Any bond payment by any insolvent nation in the Euro Zone will trigger a bailout crisis similar to the one in Cyprus. We have already had one crisis in 2013 and it is not even May, June and July yet when government revenues shrink dramatically in Europe and governments search for ways to make ends meet. Be ready for another summer of fiscal disturbance in Europe.
Monetary Lessons From the US and Japan
Despite the controversial nature of QE infinity in the US and Japan, it cannot be argued that both policies have had a remarkably positive effect on the economies of both countries. While M2 money supply and money velocity haven't increased dramatically leading to subdued inflation, both programs have instilled confidence in the financial markets in both countries that the government is not going to embark on a premature monetary tightening policy that has lead to double-dip recessions in the past. This has emboldened businesses ever so slightly to not layoff en-masse anymore and instead focus on investment and revenue generation. The policies are sowing the seeds of a positive feedback loop that will enable both economies to escape the recessionary spiral and enable robust economic growth in the years ahead. Exactly, the opposite is happening in the Euro Zone, where the ECB has had too tight a grip on monetary policy:
While M2 Supply (the broadest measure of actual money in the economy) has grown by 8.5% in the US in 2012, it has only risen 4.4% in the Euro Zone. It is important to realize that the Euro Zone has a larger population than the US, yet it has lower GDP and lower per-capita GDP. Nobody is going to question that the American worker is more efficient than the European worker, but that is not the point here. The table below says that for each unit of money printed (M2), the US gets more output produced. In 2012, the GDP output per M2 supply ratio is 1.1 in Europe and 1.45 in the US. In 2008 prior to QE, the ratio in the US was a much lower 1.36.
As the Fed and the banks have increased the money supply, significant growth in output and productivity has come about! It could be argued that the ECB needs to implement a significantly more accommodative monetary policy in order to lift Europe out of the doldrums. The restriction in the rate of growth of the monetary supply is hampering economic growth. The ECB is making the same mistake the US did during the Great Depression. The current monetary policy of the ECB is fueling the recession in Europe and needs to be changed.
Trading Blueprint for the King Dollar Times
Based on comparative economic analysis we are poised for a future where the dollar will become stronger and trade higher. The 3 biggest trading partners mentioned in the US Dollar index - Europe, Japan and Britain - have either already undertaken significant currency devaluation programs or are about to undertake one. I think that the ECB will undertake an LTRO Infinity bond purchasing program similar to the programs implemented in the US and Japan. After all, there is now conclusive proof that these programs have instilled financial stability in the markets and have restored business confidence resulting in rising stock prices and better employment.
How does one benefit from these prospects? At present, I recommend an aggressive short exposure to the Euro as I have outlined in my previous article or entering into a long dollar position via the US Dollar Index ETF or its 3 times leveraged counterpart UUPT.
The Next 6 Months
We are likely to see continuing weakness in the European economic numbers over the summer months. As such, short exposure to European markets is recommended for the next 3-4 months. You can short the German market (NYSEARCA:EWG) or the French market (NYSEARCA:EWQ). You could consider Italy (NYSEARCA:EWI) as well but that has corrected about 15% already so further downside may be somewhat limited. You have to watch for any strong support, however , since the moment news of easing comes in the stock markets will be boosted so you have to cover your shorts quickly. In addition, commodities denominated in dollars should see downward pressure on their prices. You want to be short oil (NYSEARCA:OIL) and short gold (NYSEARCA:GLD). For the near term, I would avoid adding short gold exposure until the Cyprus crisis gets resolved. You also should avoid investing in any stocks with European exposure and focus on companies that do their business in America. Companies in the restaurant sector, travel, industrials and financials should be preferred as they will benefit from a strong dollar, falling commodity prices and rising consumer confidence in the US. Some of my favorite companies here are Dunkin Donuts (NASDAQ:DNKN), Buffalo Wild Wings (NASDAQ:BWLD), JB Hunt Transports (NASDAQ:JBHT), Paccar (NASDAQ:PCAR) and TCF Financial (NYSE:TCB).
6 Months And Later
After news of the additional easing has arrived, you will want to go long the European country ETFs - EWG, EWQ, EWI, EWP - to bet on the European turnaround story and hedge your long exposure with euro currency shorts as the declining euro may eat into your profits. At this point, once the crisis has passed or in the middle of the crisis, I recommend shorting gold aggressively via the 3x leveraged Short Gold ETF (NASDAQ:DGLD) and adding short volatility exposure via XIV. At that point, you may go long the US market as well via SPY or via 3x leveraged ETF such as UPRO.
Disclosure: I am long UUPT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.