One of my favorite themes in recent weeks has been the possibility of the dollar staging a significant move up by summer in a sharp reversal of the dollar’s nearly 15% decline over the last nine months.
I’ve thought that much of this strength would come on the back of a euro that would be stressed by some sort of sovereign debt flare-up as I outlined loosely two weeks ago in Dollar Set to Rise?
While I do think the euro is going to become less attractive to investors due to the likelihood of additional liquidity and/or solvency issues reemerging in the euro-zone, I am coming to believe that more of the dollar’s move up is likely to be driven by its own strength as investors move toward the greenback even if problems in Europe are minimal.
This new belief is born of the fact that Mr. Bernanke is back at the table and there’s a chance that he’ll be better than ever.
By back at the table, I mean that Mr. Bernanke is beginning to gauge investor sentiment around the Fed’s current round of bond buying and that of an additional or potential third round of bond buying. He bluffed the markets into believing that the Fed might embark on a major round of bond buying back in late August of last year and the markets reacted by pushing down the dollar due to the potential increase in supply.
It was a bluff because $600 billion is nothing in relation to M2 of about $8.8 trillion nor was it significant in the scheme of the initial bond buying estimates coming out of the big banks of $2 to $10 trillion.
Mr. Bernanke’s bluff did, however, rouse the risk-on assets with large gains having been posted in equities but even larger, nearly absurd, gains posted in some segments of the commodity complex. All of this on that 15% decline in the dollar though.
I may be alone in this opinion and based on everything I read it seems I am, but Mr. Bernanke is an unparalleled economic engineer – whether he’s supposed to be is a conversation for another time – and the monetary policy option of communication that he chose last August was necessary to bring some dynamic flow back to the system if only in perception - and it was far more effective than the token $600 billion of fresh liquidity.
Mr. Bernanke, however, knows, and probably more so than his critics, what his critics point out endlessly - that a liquidity driven economic recovery is a temporary solution at best.
Flooding the system with liquidity in late 2008 and 2009 was the best and only option among bad options to keep an economy that runs on money and credit from grinding to a halt, as was the bluff to flood the system again last year even if it turned out to be more like a gushing trickle.
It’s done nothing though to improve the real flow in the economy – or inflation and one of the Fed’s official mandates – as I examined three weeks ago in looking at the velocity of money that is sitting at a thirty year low due to the awkward dynamic between mushrooming M2 and too much economic slack.
And so now, the temporary solution needs to be replaced by a lasting solution and that is an economic recovery that eats up slack on a strong currency and eventually rising rates. It is this sort of a recovery that could bring the economy closer to a higher gear as was seen in late 1997 when the velocity of money hit its current thirty year high of 2.13, GDP growth was close to 7.0% on a year-over-year basis, the fed funds rate was close to 5.0% and the dollar index was at 100.
That is a picture of economic strength – 2.13 velocity of money, 7% GDP growth, 5.0% fed funds rate and the dollar index at 100 – and it’s the picture that needs to be recreated, or at least in part, from today’s 1.67 velocity of money, 3.0% GDP growth, 0% to 0.25% fed funds rate and the dollar index slightly below 76.
Unlike much of what I read, I am confident that Mr. Bernanke will do his best to steer us toward such a recovery if at all possible and it may not be due to the debt mountain of the last thirty years, but this puts Mr. Bernanke in the very awkward and challenging position of weaning investors off a constant drip of Fed liquidity via bond buying, perhaps around POMO too, and to a strong dollar, higher rates recovery.
If he does this subtly and organically as I think he will try, Mr. Bernanke may never face the daunting task of extricating the Fed from its recent balance sheet escapades in one damaging shot.
The reason I think Mr. Bernanke is beginning to test these waters is because two of his officials were out two Mondays ago putting out the exact opposite messages, similar to what we saw last fall around the Fed’s second bond buying campaign.
Specifically, Dallas Federal Reserve Bank President Richard Fisher said that he may vote to shorten the Fed’s current $600 billion bond buying program and he was the first Fed official to do so and test what may be a third rail for investors.
"If at any time between now and June, it should prove demonstrably counterproductive, I will vote to curtail or perhaps discontinue it," Mr. Fisher told a banking trade group and, in part, due to the fact that “the liquidity tanks” of the economy are full "if not brimming over." Mr. Fisher also insinuated that further Fed accommodation could hurt job creation and cause investors to expect rising inflation. In summary, the recovery is "well under way.”
On the very same day - and I just love the ingenuity of the hedge - the President of the Atlanta Fed was out talking about how the Fed may want to consider a third program of bond buying if an oil shock begins to appear. Interestingly, within this message was a bit of internal treading with Mr. Lockhart saying that his first instinct is to be “very cautious” about initiating another round of bond buying once the current program comes to an end in June, but that he was open to the possibility if oil remains high or moves higher.
Not surprisingly and perhaps summing up Mr. Bernanke’s own philosophy in a speech to the National Association of Business Economics, Mr. Lockhart said, “I prefer a posture of flexibility as regards to policy options.”
While Mr. Lockhart doesn’t actually vote on the FOMC until next year, his message was very much the opposite of Mr. Fisher’s message put out on the very same day and this spectrum of possible policy options from the Fed is rather similar to what we saw last fall with certain members included in what I think of as a trial and error cycling or dosing around Fed policy.
In fact, Mr. Lockhart was back out this past Friday talking about how there was a "high bar" for QE3 as the President of the Philadelphia Fed was talking even tougher, saying that the Federal Reserve should tighten monetary policy aggresively withing a year.
In my view, this is only the beginning of the very subtle cycling we’re about to witness in the coming months as Mr. Bernanke determines the exact but smallest possible dose of Fed bond buying, none if possible, that investors will accept without the two-year old risk rally and its psychological good tidings coming to a screeching halt.
It can slow or correct, but it cannot crash.
Perhaps the risk rally can even continue at the moderated third year bull-market pace if Mr. Bernanke is successful in replacing liquidity with language as he was this past Thursday in announcing an anticipated but new aspect of his communications campaign or quarterly press briefings.
Investors cheered this approach with the equity markets moving up slightly from the time of the announcement on top of the day’s already hefty gains as the dollar moved up ever-so-slightly. In addition, there was solid follow-through on Friday.
In fact, I think Thursday’s events provide reason to think that Mr. Bernanke can succeed at the daunting task of weaning investors off of the printing press and I also think the chart of the dollar index suggests that he’s more likely than not to succeed for at least a little while.
(Click chart to enlarge)
Specifically, while the trendline of support in the dollar index’s weekly chart was punctured recently, the equivalent trendline in the quarterly chart remains intact and shall remain intact so long as the dollar index remains above about 75 through the end of this quarter.
As you can see in the chart above, the bottom trendline of that Symmetrical Triangle has served as strong support to the dollar index for more than three years now and the recent move below 76 of the dollar index may serve as a successful near-test of that support, creating the possibility of a bounce up and off of that trendline area.
As important to the likelihood of a rising dollar and Mr. Bernanke’s potential success in weaning investors off of the Fed’s liquidity programs, at least temporarily, is that top trendline of the Symmetrical Triangle drawn in because it reinforces the idea that the dollar index is likely to move up higher to fill in the nose of the Symmetrical Triangle.
In fact, this top trendline suggests the dollar index will climb to about 84/5 while this chart also makes possible a spike higher to say, 86 or 88, in the next two to three quarters.
How Mr. Bernanke accomplishes what seems to be an unbelievably daunting task, I don’t know even with last week’s excellent start, but I think it could be the inverse equivalent of Volcker’s tough love policy, for lack of better way to put it, back in the summer of 1981 and this need not mean that Mr. Bernanke raise rates immediately if he somehow signals, slowly, that the Fed’s accommodation is going to lessen as the economy remains in growth territory - even if it is tepid at best.
After all, this is what made sense back in the fall in thinking about QE2 – let the economy replace liquidity under Mr. Bernanke’s careful steering through communication. In this way, Mr. Bernanke could guide investors off of a weak dollar rally and toward a strong dollar, higher rates recovery and I think investors will be happy for it if it’s done in the right way.
And, as if on cue, the aforementioned cycling through his Fed officials allows Mr. Bernanke to discover the right way over time.
Interestingly, it appears this effort will come relatively soon – and it did in part yesterday – based on the fact that the dollar index’s charts are pointing to the dollar’s likely climb by summer or fall and this tells me that the Fed is less likely to have agreed to embark on another round of bond buying by that time. In fact, the pattern placement of that same chart suggests that the Symmetrical Triangle may break to the upside from that top trendline and to about 105.
This, in turn, would suggest that the Fed’s bond buying ways are about to be replaced by monetary policy of a different sort and perhaps the sort that will offend fewer and please more as there’s less need for the Fed to monetize the debt.
The person who will be most pleased by such a replacement? Mr. Bernanke himself, I hope, as he should be if he pulls it off.
Disclosure: I am long UUP.