Warning Bells Ring Critical for the U.S. Dollar

Includes: CEW, IEF, TIP, UDN, UUP
by: Daily Trading

Now I would like to pose this question: are rising inflation expectations globally a bearish omen for the world's most widely held (reserve) currency, i.e. the USD? Let me also pose this question: under a high inflationary environment globally, wouldn't you be best served by searching for yield, that is, investing in those currencies offering the highest yield? Of course, the currencies that come to mind are of the emerging market variety and not USDs, which offer little or no yield.

I would have a lot of trouble being invested in USDs when inflation expectations are rocketing globally because the USD has always performed extremely well under deflationary conditions, and so too have low yielding assets, at least of the paper variety.

I see little reason why there should be any fundamental change to the way the USD behaves over the coming months. Just yesterday, Bill Dudley confirmed what Bernake said in his testimony a few weeks ago. The essence of Dudley's talk before an audience at NYU Stern School of Business yesterday was the following:

  • Fed is not an exporter of inflation and not to blame for inflation in emerging markets.
  • It would be unwise for the Fed to overreact to recent commodity price pressures.
  • Current Fed policy is in the interest of the world's economy.
  • Rates likely to stay low for extended period.
  • Sees several areas of vulnerability for the U.S. economy and sees need to be ever watchful for any price bubbles.

I am not in the business of being a missionary man and passing judgment as to whether or not Dudley or Bernanke are right or wrong. My "job" is to keep on the right side of the market. From what Dudley and Bernanke have said ... don't expect any change in the behavior of the Fed over the coming weeks/months, continue to expect more of what we have witnessed over the last six months.

Now beneath the scenes a "situation" is developing in the U.S. bond market, which may well have deep repercussions for other asset classes. The breakevens are close to breaking to multi-month highs. Below is the U.S. 10-year break-even. It is within a few days of closing at a five year high! I always like to look for out-of-character behavior in financial markets, or tipping points. I think we are at that point right now! Once we see the U.S. 10-year break-even close above 2.5%, then it will likely lead to concerted investing in "inflation hedges" by the crowd. Note the USD isn't the best inflation hedge on the planet!

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Just what are the odds of the U.S. 10-year break-even breaking to the upside? Well, if you are a believer in world financial markets being highly interconnected, then the chart below may provide your answer. I created my own proprietary Global Break-even Index. In essence, it is an equally-weighted index of the G8 10-year break-even indices (the 7-year for Japan). Note that this index is already trading at a multi-month high!

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I think the rush to invest in the "inflation trade" is just getting into gear and we have quite likely reached the tipping point for the USD and associated low yield paper currencies.

Disclosure: I am long CEW, FXA.