Leading indicators with strong correlations and huge lead times suggest the trade weighted value of the dollar will drop, reversing the counter trend move up that began in the fall of 2011. The bigger downtrend that began in March 2002 should resume soon.
Here is the index we are talking about:
The current account, which is the broadest measure of the trade deficit, has a significant leading correlation with the dollar. When Americans run a trade deficit, i.e. consume more than they produce, it eventually weakens the dollar.
American over consumption reached its height with a current account deficit of 6.5% of GDP in the last quarter of 2005. The chart suggests this would have its maximum downward impact on the dollar at the end of 2014.
The trade deficit is a problem in its own right. Warren Buffett compares America running a trade deficit to a wealthy farm family living beyond its means. They sell a few acres here and there to fund the lavish lifestyle, eventually exchanging the life of wealthy land owner for that of tenant farmer.
When trade flows one way, ownership of assets flows the other. To finance our over consumption since 1983, Americans sold almost $7 trillion of U.S. assets to foreigners. This is a net figure over and above whatever increase in foreign assets Americans own abroad.
A bit more surprising, but with an even stronger correlation is the influence of the capital gains tax rate on the dollar. Low rates seem to mean a weak dollar.
Conventional wisdom holds that a low capital gains rate encourages growth and investment and should theoretically strengthen the dollar. Reality appears to be different, where a low capital gains rate encourages consumption and financial investment at the expense of real investment in productive capacity. It could be said a low capital gains rate shifts resources from Main Street to Wall Street. The influence of the capital gains rate on economic growth is discussed here. This article reviews the impact on employment.
In the chart above the correlation with the monthly trade weighted index suggests the dollar has hit bottom, whereas the correlation of 7 year moving averages suggests the dollar has a lot further to fall. The 2013 increase in the capital gains tax rate should begin having an upward influence on the dollar in 2021. The chart shows the capital gains rate of 20% plus the 3.8% healthcare surtax or 23.8%.
The model of the dollar below uses rates of change in the two variables above along with some other indicators. It suggests the dollar should drop about 11% in the next year and a bit more in the few months after that. Other variables in the model have shorter lead times than the indicators above, so the model only looks out to October 2014.
The Dollar and Stocks
Having seen various comments and assertions that a weak dollar would be good for stocks, I decided to look at the data. While the dollar has trended down since 1985 and the stock market up, the correlation seems to flip from positive to inverse without a pattern- or at least a pattern I recognize.
When I examined rates of change over one year periods (not shown) there was virtually no correlation between changes in the dollar and stock market changes at any of the many lead times I tested. While there may be some correlation between the dollar and stocks for daily trading purposes, it does not appear to translate into a meaningful long-term relationship.
I am expecting the stock market (NYSEARCA:SPY) to fall and don't expect a falling dollar to save it. This is not a time to hold all your eggs in a dollar-denominated basket.
If both the dollar and stock market fall international bond funds (MUTF:BEGBX) (NYSEMKT:FAX) may be a good resting place for investments. A falling dollar might also be good for gold (NYSEARCA:GLD), but I don't have a quantitatively backed opinion about its near-term prospects.
Returning America to sustainably growing wealth probably requires that we stop consuming more than we produce. The drop that's forecast in the dollar might accomplish this or it might take another crisis. The great recession and financial crisis helped cut the current account deficit by about half, but by itself the crisis was insufficient to restore a balance between what Americans consume and what they produce.
Disclosure: I am short SPY. 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.
Additional disclosure: There is no guarantee analysis of historical data their trends and correlations enable accurate forecasts. The data presented is from sources believed to be reliable, but its accuracy cannot be guaranteed. Past performance does not indicate future results. This is not a recommendation to buy or sell specific securities. This is not an offer to manage money. I am long BEGBX