A Short-Term U.S. Dollar Bounce

Sep.21.11 | About: PowerShares DB (UUPT)

There has been a formidable bounce in the USD, most notably documented by speculators going long the USD for the first time since July 6th, 2010. That didn’t work out well last time, and it won’t this time either:

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The only time in the past 20 years that the USD has seen a sustained dollar rally was during the budget surplus years of Bill Clinton.

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Although there have been sharp short term rallies, most notably in 2008, the trend has been decisively downward. In fact, as the USA’s economy was humming along in 2005 to 2007, the all time low was reached on the dollar index at $71.05.

Intuitively, it appears the short term dollar rally trade is driven by a risk on / risk off appetite; when there is panic in the markets the USD rallies. Comparing with the UUP ETF and the SPY ETF, this relationship doesn’t look as strong as one might think, with the USD actually outperforming the SPY over the past few years:

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The S&P’s large dips are not offset by the dollar indexes rallies, although there is a fairly strong correlation outside of these events. The numerical correlation reading is -0.01, which is essentially zero, on a 200 period daily correlation measure:
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This is curious given the “safe haven” status of the USD as the world’s reserve currency. Digging deeper into what makes up the UUP, it becomes apparent why this relationship is so. Taken directly from PowerShares ETF website:

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The UUP is made up of USDX futures contracts, which are made up almost entirely of Euros, Yens and British Pounds. Thus the explanation for the USD’s strength as of late is a combination of the risk off market sentiment and comparative performance. The question is how does the USA compare to the Euro, Japanese Yen and British Pound?





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The graph I find most telling is the government gross debt as a % of GDP, remember that these percentage points equate to billions and billions of dollars. Therefore, for the US to regain the budget surpluses of the late 1990s through fiscal measures, it would require greater austerity measures than what we’ve seen in Europe, or taxes raised substantially on everyone, not just the millionaires and billionaires.

With the surpluses now being budgeted for 2020, and that is with CBO’s laughable forecasts. To see just how realistic the CBO is, below is its forecast from 2000 to 2011.

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If everything had gone to plan, the USA would have a $889 billion surplus, proving linear forecasts are more or less bunk. It amazes me that given the run the USA had been on up to that point, no one thought to include at least one major setback in the next 11 years.

That leaves one option, printing money. Buffett correctly pointed out that the USA has a AAAA rating is his book due to this fact, and he is largely correct. The consequence of this, a continuing downtrend in the dollar.

I expect the economy to improve eventually, as I’ll always be long human ingenuity, but remember economic strength is not an indicator of dollar strength. Budget surplus/deficits have been strongly linked to dollar strength in the past 20 years, and the most likely way the debt problem in the USA will be dealt with is via continued money creation, not revenue growth or large cuts to programs. Although Europe is also struggling, they are ahead when it comes to deficit and austerity measures, plus have not dug as deep of a hole with failed Keynesian economic theory. Perhaps one day the USD will recover, but that day is not today. Therefore, things are looking down for the UUP.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in UDN, SPY over the next 72 hours.