The two most dominant financial market themes lately have been the congressional debate over whether the U.S. debt ceiling should be raised and with the continued weakness of the U.S. dollar. Ironically, both factors represent polar opposites of the long-wave economic spectrum, namely extreme inflation (dollar weakness) and extreme deflation (debt contraction). Equally ironic is gold’s historical tendency to benefit from both extremes of the economic long wave.
Let’s start with the dollar. While the U.S. dollar index hasn’t yet broken its low from early May, the PowerShares U.S. Dollar Index Bullish Fund (NYSEARCA:UUP) has made a new low for the year as of Tuesday, July 26. The UUP is our favorite proxy for the dollar index and it’s not uncommon for UUP to lead the actual dollar index lower or higher at key turning points since it’s a favored trading vehicle for hedge fund managers.
The significance of Tuesday’s action in the UUP is seen in the daily chart shown here. UUP made a new lifetime low today and in doing so paved the way for another round of dollar weakness and commodity price strength. Notice in the chart shown below that UUP has been led lower by its 120-day moving average every step of the way in this long downward trend since the previous dollar rally last spring.
Indeed, the 120-day MA has acted as a powerful trend line/resistance for the UUP and in each of the instances price has attempted to break out above the 120-day MA, the moving average turned back the abortive rally attempt and UUP ended up making a lower low. The last such attempted breakout above the 120-day MA occurred earlier this month with UUP unable to close above it.
Regarding the latest weakness in the dollar index, financial analyst Graham Summers observed in his latest column: “As you can see, aside from a brief dip at the beginning of July, the US monetary base continues its near vertical trajectory, which tells us that the Fed continues to print money despite QE2 ending.”
This provides some context behind the latest dip in the dollar’s value despite the formal ending of the Fed’s Treasury purchase program on June 30. As Mr. Summers has made clear, it appears the Fed hasn’t completely abandoned its loose money policy despite political pressure from both sides of the political spectrum to cease “printing money” in order to relieve the upward pressure on commodity prices. The question everyone (namely those outside the higher circles) wants to know is, “Why?”
Aside from the obvious attempt at “juicing” the uninspired economy, there’s another motive at work here behind Washington’s weak dollar policy. It has been observed that a weaker dollar has direct benefits to the U.S. stock market since nearly every large cap company in the S&P 500 has major overseas operations. For instance, the leading U.S.-based corporations generate a substantial portion of their profits from overseas operations. McDonald’s (NYSE:MCD), for instance, generates 65% of its profits overseas while IBM (NYSE:IBM) generates 61% of its profit in foreign markets. Cisco (NASDAQ:CSCO) generates 48%, Pfizer (NYSE:PFE) 47% and Caterpillar (NYSE:CAT) 53%.
Further, every company with European profits will see its euros translate into a higher level of U.S. dollars in their quarterly earnings reports due to the weaker dollar. In other words, the higher corporate profits of the U.S. multinationals in recent years have been tremendously helped by a weaker dollar.
This point was recently touted by Federal Reserve officials, including Chairman Ben Bernanke and New York Fed President William Dudley. Both have used the increase in exports from the U.S. to foreign markets as a justification for the Fed’s loose money policy. Despite a weak housing market and high unemployment, exports have increased in the last two years since the stimulus began. Exports accounted for a record 13.4 percent of gross domestic product in the first quarter, compared with a 10-year low of 9.2 percent in the second quarter of 2003, according to the Bureau of Economic Analysis.
“The Fed’s easy monetary policy has helped spur foreign demand for U.S. products by weakening the dollar,” wrote Bloomberg News on July 25. “Since Bernanke hinted last August that the Fed might embark on another round of bond purchases, the greenback has declined 9.4 percent against a basket of currencies for six major U.S. trading partners … UBS now predicts net exports will boost economic growth in the second quarter by 1.5 percentage points, up from an earlier assumption of 0.4 percentage points.”
Obviously the Fed has a vested interest in seeing to the global competitiveness of the U.S. multinationals. But what about the domestic economy? At what point does the Fed’s loose money policy put too much inflationary pressure on retail prices here in the U.S.? Will the Fed stop pumping once the retail gasoline price exceeds the psychological $4.00/gallon level? When unemployment exceeds 10 percent? At what point does Bernanke realize that his efforts at stopping the overwhelming force of long wave deflation by creating artificial inflation are ultimately futile?
One reason why the Fed’s loose money policy has been so successful in pushing up commodity prices (and thereby preventing deflation from gripping retail prices) is that an important longer-term cycle that bottomed in 2008 has been in its peaking phase. I’m referring to the 6-year cycle, which is scheduled to peak around October of this year. Once the 6-year cycle peaks the Fed will likely find it much more difficult to stimulate the economy by simply “printing” money and weakening the dollar.
The weak dollar policy has served the last two administrations well but this policy can succeed for only so long. At some point the combined cyclical and structural forces of deflation – which will culminate in late 2014 when the 120-year cycle bottoms – will prove overwhelming and no amount of policy will contain it. The Fed can only weaken the dollar to help the multinationals for so long before grassroots political backlash and an overly weak dollar come back to haunt it. Fed Chairman Bernanke is too intelligent to let that happen. The most likely outcome isn’t an economy that is killed by a weak dollar but an economic collapse by 2014 led by deflationary forces which Bernanke, et al, have no control over.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.