US$ Fundamentals
Intermediate-term (6-12 months)
Steve Saville
email: sas888_hk@yahoo.com
Jul 11, 2006
A question we occasionally
get asked is: how can we be bullish on the US dollar when the
dollar's fundamentals are so bearish? The answer is that the
dollar's fundamentals -- at least, the fundamentals that matter
the most as far as intermediate-term currency trends are concerned
-- are bullish, not bearish.
As discussed in many previous
commentaries, the real short-term interest rate is the most important
fundamental driver of the dollar's intermediate-term trend. The
real US short-term interest rate began to decline during 2001,
dropped into negative territory during 2002, and remained negative
until the first quarter of 2005. As a result, the Dollar Index
was very weak during 2002-2004. There was the occasional multi-month
rebound, but the direction of the intermediate-term trend remained
down.
However, the interest rate
backdrop began to change in mid 2004. Specifically, the real
yield on a 3-month US T-Bill bottomed at around minus 1.60% at
this time and began to trend higher. It moved into positive territory
during the first quarter of 2005 and has continued to rise, hitting
a new multi-year high of 2.3% at the end of last week.
The following chart depicts
the relationship between the real T-Bill yield and the Dollar
Index. Notice that the Dollar Index continued to make lower lows
and lower highs until the real T-Bill yield crossed into positive
territory, at which point its intermediate-term trend reversed
upward.
The real T-Bill yield is calculated
by subtracting the "expected CPI" (an estimate of how
fast the market believes the dollar will lose its purchasing
power in the future) from the nominal T-Bill yield*. The expected
CPI is, in turn, calculated by subtracting the yield on a 10-year
TIPS (Treasury Inflation Protected Security) from a standard
10-year T-Note. So, with the Fed unlikely to move the nominal
short-term interest rate by much in either direction over the
next few months, particularly if the stock market continues to
decline, any substantial change in the real T-Bill yield will
have to come about due to a substantial change in the expected
CPI. That's why we've said that the biggest threat to our intermediate-term
bullish view on the US$ would come from a rise in inflation expectations
(if the nominal interest rate remained unchanged then a rise
in the expected CPI would result in a corresponding fall in the
real T-Bill yield).
As things currently stand,
the "expected CPI" has just turned down after reaching
the top of its 2-year range (see chart below). If stock and commodity
prices have recently commenced intermediate-term declines (we
think they have) then the "expected CPI" will probably
trend lower over the coming months. This is because most people
wrongly associate falling asset prices with an increasing risk
of deflation, even though the opposite is generally true since
falling prices prompt the central bank to abandon any inflation-fighting
pretense and enact policies that ultimately lead to higher inflation.
Alternatively, if stock and commodity prices have just experienced
a bump on the road to significantly higher prices (unlikely,
in our opinion) then the "expected CPI" will probably
break upward from its 2-year range within the next couple of
months. If this happens and the Fed fails to react by hiking
the nominal short-term interest rate at a quickened pace then
the real T-Bill yield will experience a sharp fall and the Dollar
Index will probably languish near its recent lows.
Long-term
The weakest currencies over
the long-term will generally be those that have experienced the
fastest rates of supply growth and the strongest currencies will
be those that have experienced the slowest rates of supply growth.
Factors that affect the relative demand for currencies -- interest
rate differentials, for instance -- will often dominate exchange
rates over shorter time periods, but over the long-term it's
the relative inflation rate (the relative rate of growth in currency
supply) that dominates.
Some of the most popular reasons
cited for being long-term bearish on the US$ are therefore not
directly relevant. For example and as discussed in previous commentaries,
the large US current account deficit is not, in itself, a reason
to be bearish on the dollar. However, in this case the current
account imbalance is a symptom of an inflation problem and the
inflation problem -- the current one and the expected future
one -- IS a reason to be long-term bearish. Also, a large US
federal government budget deficit is not, in itself, a reason
to be bearish on the dollar. In fact, a large government deficit
would put UPWARD pressure on the dollar's exchange value IF it
were financed via direct taxation. It is only a negative to the
extent that it results in inflation (money supply growth). Of
course, the current large and growing US federal government deficit
is being financed primarily by the hidden tax known as inflation,
thus allowing the administration to market itself as a 'tax cutter'
even while the overall tax burden soars.
The relatively large amount
of US$ inflation during 1997-2002 set the stage for a long-term
bear market in the dollar's exchange value. However, most other
major currencies have been inflated at faster rates than the
US$ over the past three years and if this trend continues then
the Dollar Index's long-term bear market is probably over. Under
this scenario the US$ would likely fall much further relative
to gold over the next five years, but fall less, relative to
gold, than most of the other major currencies. In other words,
the US$ would become the strongest of a weak bunch. We don't
see this as the most likely scenario, though, hence our long-term
bearish view on the 'buck'.
The way we see it, the on-going
spending commitments associated with the 'unwinnable' war against
terror, combined with the costs of re-building New Orleans and
the virtual certainty of the Fed adopting a loose monetary stance
once asset prices become sufficiently weak, will eventually result
in the US$ regaining its lead in the inflation race.
Steve Saville
 email: sas888_hk@yahoo.com
Hong Kong Regular financial market forecasts and analyses are provided at our web site:
http://www.speculative-investor.com/new/index.html. We aren't offering a free trial subscription at this time, but free samples of our work (excerpts from our regular commentaries) can be viewed at: http://tsi-blog.com
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