As predicted in this article, the improving trade deficit numbers in the U.S. weren't going to last. The U.S. trade deficit widened to $39.1 billion in July 2013. This brings me to an interesting correlation. I want to bring to the attention of investors that the U.S. trade deficit can be a leading indicator for weakness in the U.S. dollar. I believe that the U.S. trade deficit is about to get worse in the near future due to several reasons: higher interest rates, tensions in the Middle East and the debt ceiling. This will lead to a lower U.S. dollar index.
The following chart gives the monthly U.S. trade deficit (red chart) versus the U.S. dollar index (blue chart). If the trade deficit widens (red chart goes down), the U.S. dollar index will drop (blue chart goes down).
As you know, a trade deficit means that imports exceed exports. Americans buy more stuff from foreigners and in exchange they give money to these foreign traders. This money needs to be in the currency of the foreigners. Let's say an American buys a Chinese TV. He will have to pay yuan to the Chinese merchant. To do this, he will convert U.S. dollars to yuan. This will lower the value of the U.S. dollar.
The other way around is also true. China has a trade surplus and will sell its goods to America in exchange for U.S. dollars. These U.S. dollars will be converted to yuan, otherwise the Chinese merchant can't do much with the U.S. dollars in his country. This will increase the value of the yuan.
Of course, there is a lag between trade and currency conversion. This lag is approximately 1 year. As a consequence, the trade balance is a leading indicator for the strength of a currency. The higher the U.S. trade deficit, the higher the probability of a decline in the U.S. dollar index.
Recently, the trade deficit has improved a lot (since 2010); the U.S. dollar strengthened with it. But I believe this improving trade balance has started to roll over. I mentioned three reasons: higher interest rates, tensions in the Middle East and the debt ceiling. Higher interest rates were prevalent in the last 4 months. The value of U.S. Treasuries have declined almost 20% in this short period of time accompanied by selling from China and Japan. As tapering is on the table, I expect this trend to continue. As for the tensions in the Middle East, the odds of a strike in Syria are getting higher every day and will not be beneficial to the trade balance of the U.S., due to higher defense spending. Finally, the debt ceiling debate will go full force in September when the Federal Reserve runs out of options to avert its debt limit. Dividends from Freddie Mac and Fannie Mae have averted the limit for a part, but with higher mortgage rates to come, this story isn't going to end well.
To further show evidence of the validity of this correlation between the trade balance and the currency value, I will give an example of what's happening in Japan. Macro Man's blog indicates that the Japanese yen is about to collapse if we look at the trade deficit numbers. As the blue chart goes down, the yen should weaken considerably. The USD/JPY ratio should be going to 150 and it is right on track to go to that number as we speak.
If you know that the trade deficit is a leading indicator for currency weakness, you can predict the collapse of the U.S. dollar by just looking at the trend in the trade deficit every month. You can position yourself for this collapse in the U.S. dollar by buying precious metals (NYSEARCA:GLD), (NYSEARCA:SLV) and commodities.