A Contrarian Take on the Dollar: Why It Will Get Stronger

by: David Andrew Taylor

Typically, when interest rates are going up, so is that country's currency. Typically. For the U.S. dollar, things are about to get interesting. Regardless of how many interest rate increases are left (what, maybe two, if any?) from that point the dollar will collapse.... or so says every pundit out there with a vocal chord.

I got into a debate about a month ago where I argued that there were more than enough reasons for the greenback to be supported. The biggest reasons were that the U.S. has more to offer in the way of opportunities to hold dollars. Our equity markets have historically created more wealth than other equity markets in the world. Our financial institutions have the ability to finance the world, and have done so. At one time, London was the world's financial center. Not to diminish Great Britain's prominence in the world of finance, but I'd say that New York has arguably taken over that role.

However, many out there are quick to point out a trade deficit that looks set to punish the greenback into oblivion. Really? You say that the -$800 trade deficit is going to collapse the dollar? You can't be serious?

If the dollar was going to succumb to the trade deficit, wouldn't it have already done so? There's a -$800 billion trade deficit that didn't just happen this morning. It's been happening since the early 1990's. Umm... that's more than enough time for the dollar to have begun to slide. Instead. during that time, the U.S. dollar has gone through cycles that included a period when the euro was challenged by way too many as being a complete failure. There were individuals out there that figured we'd be trading francs, liras, and marks once again. Umm... what are your thoughts now? You're probably sitting there saying something like this: The U.S. dollar is going to collapse and the economy is going to enter a period that makes the Great Depression look like a one-time decline in the growth of GDP.

Umm... let's be realistic.

I'm positioning myself that the dollar does in fact decline once the Fed takes out the word "yet" and replaces it with "we're going to stop here". I think the world is sitting at their desks doing exercises on their trigger fingers in anticipation of that moment. I'll certainly enjoy that ride.

Take a moment and try and imagine the entire picture once that begins to happen. The U.S. dollar will get a blow to the stomach. Meanwhile, gold will rise (since it's priced in dollars) and so will oil as it is priced in dollars as well. Other commodities that are being bought up by Americans are going to rise because of a quick devaluation in the dollar. What's that all spell.... you know, higher prices? It spells higher interest rates. The Fed will be quick to react. And the dollar sell-off will be short-lived.

That's when commodities will finally get it. The Fed made it quite clear Monday that there is a need for vigilance in the face of inflation. What, did someone out there think it was just a passing phase when Chairman Bernanke wrote an entire book on inflation targeting? The inevitable Fed pause will force the Fed to start right back up again. Ahh... the allure of higher interest rates. If you live in, say, Japan, where the bank rate has been sitting at a lofty 0.15% for years, the draw will be too hard to resist. Money will either stay here, or the flow will continue. In Europe, the bank rate sits at a steep 2.5% and will likely move up another .25 basis on Thursday. Europeans will be enticed to those rate levels.

But, then there's another affect to higher rates: A dead economy. Paul Volker solved the speculative bubble in 1980 with interest rates all the way to the upper teens. People finally stopped maxing out their credit cards to buy gold only to sell their gold at a profit, and pay off their credit cards.... only to max them out again to buy more gold.... Inflation was finally under control. The cost: A whole bunch of jobs, growth in GDP, a crisis in confidence, and a Presidential race. This time: We'll see jobs take a dive, growth in GDP will fall...

but the dollar will rise. Yes, I said that.

Need proof? I was alive during that timeframe, but was more concerned about doing jumps on my Huffy than what was happening in the economy. So, I had to look up some long-term charts for the past 30 years. Here they are. These are 30-year charts for the U.S. dollar vs. the majors. You want to look all the way to the left on all of them at the very fist white vertical bar. That's 1978 :

There was only one instance when the dollar lost ground during that time-frame, and that was against the Great British Pound. Every other instance drew money into the dollar. Higher interest rates.

And then there are all those out there that think that the deficit will make things different this time. Really? Because between 1978 - 1928, we ran a trade deficit as well.

So much for that argument.

That's what is going to make trading interesting going forward. The dollar will fall once the Fed finishes. Then the Fed will be forced to start back up again if inflation doesn't stop growing (but, that's going to be hard considering that the dollar will be losing value).

Should be an interesting period of trading for the dollar. Just make sure you're on the right side of the move.