Why a Dollar Isn't Sustainable

Includes: UDN, UUP
by: Terence Chan

I've talked about how a correction in the Japanese Yen could lead to a rally in the US dollar. Technically, charts are also portending a rally. Here is an excellent excerpt from former Morgan Stanley Chief Asia Economist Andy Xie, detailing another potential catalyst for the dollar. He talks about the rising savings rate among the US consumer:

The big change that happened is a rapid increase in the U.S. household savings rate. It happened much more quickly than I expected and has the potential to change the global economy. The economic explanation is negative wealth effect. U.S. household net wealth declined 20 percent, or nearly 100 percent of GDP. The rule of the thumb is that it would lead to a 5 percent reduction in spending. The U.S. household savings rate has increased more than that -- and continues to rise. It could rise above 10 percent next year. Because of rising savings, the U.S. trade deficit has already halved from the peak. It could halve again next year. This is why I have turned positive on the dollar.

Financial markets are still maximum bearish on the dollar. Liquidity is being channeled out of dollar into all other assets. This is why there is such a high correlation between the dollar and other assets. I think this is the most crowded trade in the world. When the dollar reverses, the short squeeze could cause a global crisis.

While both I and Mr. Xie agree that a dollar rally is in the works, I guess we disagree on the sustainability of this rally. My thesis is that the US Fed and Treasury are already too deep into their money printing activities, that they will just keep their foot on the pedal until they achieve their objective of putting the economic recovery in firmer footing. No premature withdrawing of money supply or raising of rates. He is also implying an utter collapse of all asset classes that have risen out of a falling dollar: stocks, commodities, gold, etc.

Well, for me the adage "You can't fight the Fed" still holds true. Pin the tail on the next bubble and you win (given how long bubbles can prolong).

Disclosure: Long UUP calls (short-term trade)