My Fearless Forecast For 2018: Dollar To Gain 10%+

by: Ivan Martchev

The middle of December is the traditional time to dust off the crystal ball and make annual predictions.

So far the annual predictions I started making here in 2014 have a success of 75% (3 out of 4), where only last year's prediction that gold will decline below $1000 in 2017 did not work out (with two weeks to go).

United States Dollar Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

For 2018, I think the U.S. dollar will rally big time. In 2017, the dollar reached its highest level on the first trading day of the year and it went pretty much straight down until September. In the fourth quarter of 2017, we have seen some bottoming action in the greenback. I think the chances are better than 50-50 that the dollar recovers all of the losses it saw in 2017 and makes a fresh multi-year high in 2018.

Why did the dollar decline in 2017? Primarily because the euro - the largest component of the U.S. Dollar Index, at 56.7% - had a massive unwinding of what I call "the eurozone disintegration trade." Instead, the eurozone delivered a wave of political victories for pro-EU parties in the Netherlands, France, and to a lesser degree Germany. Nonetheless, Angela Merkel's party must yet again start negotiations with the SPD this week, which originally wanted to stay in opposition. But the SPD realized that if no government is formed, they might be worse off with a new federal election, so they changed course.

Meanwhile, the ECB is in "QE mode," while the Fed is in quantitative tightening (QT) mode. The seeds have been sown for the dollar to rebound, particularly if the tax plan survives the negotiations between the Senate and the House committees, and if President Trump executes on his infrastructure program.

Another reason for the dollar to rally in 2018 is China, which I believe is in the early stages of unwinding its credit bubble. Chinese GDP is forecasted to end 2017 at $11.8 trillion while at the turn of the century it stood at just $1.094 trillion. The trouble is that at the turn of the century China's total debt to GDP ratio was about 100%, while now it stands at 400%, if one counts the infamous shadow banking system, which is conveniently omitted from many official statistics. The reason why it should not be omitted is its size, where some credible sources, not the least of which is the Brookings Institution, estimate the size of Chinese unregulated lending as larger than the size of China's GDP.

China Total Social Financing versus China Gross Domestic Product Growth Rate Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In other words, as the Chinese economy grew more than 10-fold since the turn of the century, total credit in the Chinese financial system grew more than 40-fold. I believe we have reached a tipping point in this massive credit cycle and now we are "over the hill" in the sense that GDP growth has begun to slow while credit growth is still surging. Bigger mountains of debt cannot produce an accelerating economy in China, which is a sign of a busted credit bubble.

GSCI Commodity Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The better than 50% decline in major commodity indexes in the 2014-2016 period is a direct result of this Chinese economic slowdown. One indicator to watch for Chinese economic deterioration is renewed weakness in commodity prices. China is the #1 consumer in most commodities, so their prices should act like canaries in a coal mine. Typically, busted credit bubble situations result in a hard landing which I think will be like what we saw in the Asian Crisis of 1997-1998, which had similar debt-to-GDP dynamics. The trouble is that the Chinese economy today is several times bigger than the total GDP of the local economies affected by the Asian Crisis 20 years ago.

Chinese Yuan versus China Foreign Exchange Reserves Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I think China's credit bubble will ultimately result in a devaluation of the yuan similar to the devaluation that they engineered in December 1993 to the tune of 34%. One way to see the hard landing coming is to see a sharp acceleration of foreign exchange outflows. A Chinese yuan devaluation, if it comes in 2018, is highly deflationary for the global economy and will be decidedly a dollar-bullish event.

Gold May Finally Decline Below $1000 in 2018

With two weeks to go in 2017, it looks like I will lose the bet I made with Gary Alexander in early 2017. He has agreed to enter into another bet for 2018 on the same terms - that gold will decline below $1000 at any point in 2018. That's like a binary put option on gold with an expiration date of December 31, 2018.

While some may see my entering into a second binary put options contract on gold after the 2017 one is getting ready to expire worthless is an attempt to hope that a broken clock will be right twice a day. I don't think this is the case. Thinking that gold will decline in 2018 is derived directly from the fact that I think the dollar is likely to rally in 2018, which I believe is a better-than-even-probability event.

There are already signs that the precious metals markets are weakening again, with silver leading to the downside and trading at levels not seen since December 2016, when gold bullion was near $1120/oz. I think that decline that takes gold below $1000 is likely to happen if my dollar forecast for 2018 works out.

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