In today’s turbulent global economy, perhaps the key question for most investors is whether or not the current global contraction will yield to a nascent recovery, or could things continue to get worse. As it happens, the weight of the evidence coming from a wide variety of economic data continues to suggest that the contraction, while losing some momentum on the downside, is still very deeply entrenched. In a recent survey, 7 in 10 Americans responded strongly to a query suggesting that they were fearful of losing their jobs. If American consumers remain nervous about the potential stability of their future income, American’s will continue to attempt to de-lever their personal balance sheets by saving money instead of spending.
So far, their has been virtually no improvement in retail sales, despite an uptick in confidence from the depths of the crisis low. On a global basis, the European continent is suffering amid chronic high unemployment, while in Asia the big question revolves around the longevity of the current inventory replacement cycle. As the global manufacturing center, inventory replacement can drive the Asian economic engine for a quarter or two, but more sustained growth will need to come from concentrated government spending as exports may revert to a sluggish posture later this year. Perhaps one of the key themes which is fairly clear is that the global monetary system is in strong need of re-alignment. Profligate central banking practices virtually guarantee a new cycle of competitive currency devaluations in the years ahead in what will most likely be a controlled decline. At the moment, it is in virtually no one’s interest, including China, to see the US Dollar collapse in a hail of bullets. The resulting currency market turmoil would drive rates up around the world, and would further cripple any prospect of even marginal growth. In fact, it is not an exaggeration to suggest that a major uncontrolled currency crisis at this juncture could easily send the world in a second Great Depression, which would fuel protectionist fires in virtually every corner of the globe.
For this reason it is very unlikely that the greenback will be cast asunder in unceremonious fashion. For China and other US Creditors, the path ahead is likely two-fold. First, to work within the system and seek reform of the monetary mechanism with the IMF and possibly using the SDR’s, -- special drawing rights -- as a means of correcting the long term trade imbalances. Much discussion in recent days has focused on realigning the SDR basket which is based on the value of export trade and a country's individual reserve backing. Since this process of haggling out an updated mechanism will likely take some time, creditor countries like China are also likely to, and probably have already begun, a stealth diversification process where Dollar holdings are reduced. Since Dollar creditors like China find themselves in a ‘prisoners dilemma,’ where bold steps quickly backfire with severe repercussions, the odds are high that China will seek another recourse. Since China is the primary creditor, the one high card that it presently holds is the ability to dictate when (and if) a crisis is going to occur. A currency crisis would only be evoked by a major creditor nation. In the case of China, by avoiding obvious Dollar divestitures, the Chinese can gain ‘time’ which at the moment is their most valuable asset. For China, additional ‘time’ means they can hope to install and see the benefits of a reshaping of their economy to one which shifts the focus over time from an export based model to a domestic consumption based model. China knows this process will probably take 10 years, but has a long run view of things, not often found in the West.
As a result, it is very likely that China will try to hold back the ‘dollar dam from bursting’ as long as they possibly can. This is not to say that a highly inflationary Dollar crisis may not erupt at some point in the years dead ahead. At the present time, the US Federal Reserve is embarked on the grandest monetary experiment possibly ever seen. It is highly debatable for how long global confidence will ‘hold together’ enough to prevent a self-reinforcing Dollar panic. Panics and crashes are in and of themselves the result of crowd psychology and herd thinking. It is possible that even with a number of major creditors trying to forestall a future currency collapse that such a collapse could develop in time as a result of rapidly deteriorating budget outcomes, and what could be an ever escalating set of future demands for rolling over sequentially greater and greater quantities of debt. Once embarked upon, many countries have found that the inflationary trend-mill knows only one direction, that of escalating, sequentially higher speeds. For the US, the current central bank money creation scheme seems to point to the idea that as time passes, it may be harder and harder to disembark the easy money policy, and draining excess reserves could be far too painful an outcome.
For students new to the markets it is worth understanding a typical picture that often precedes a major panic. Unlike the popular conception that ‘panics’ tend to hit out ‘left field,’ a fair amount of time they act as an exclamation point of sorts to a market trend that had been in force for some time, often years. While we are not saying that there are not occasions when crisis can erupt from ‘thin air,’ what we are saying is that a lot of the time, real panics tend to come from trends that have already been in motion for some time. The classic picture of this outcome is the curvilinear decline where a market down trend slowly gains increasing downside momentum over a long period of time. Eventually, the building downside momentum snowballs into a full-blown crisis, and prices fall precipitously in a short period of time.
This is then followed by an extended period of stabilization, stability and usually reform. In the case of the US Dollar and today’s monstrously unbalanced global trade condition, this kind of outcome makes sense when one starts to look at the individual motivations of all countries involved, and some of the policies and demographics that could define the path ahead. In the next chart we show a long term chart of the Dollar, with the dashed lines showing how a slow building exponential decline could develop in the years ahead. We do NOT attempt any level of exactness in our diagram, and include the chart simply to illustrate THE IDEA that a future Dollar Crisis could be an event that we build into slowly and steadily at first, and then more rapidly through the passage of time. In the final analysis, the worst portion of a potential Dollar crisis may not be seen for several years or more.
For investors a steadily developing curvilinear decline in any asset can be an excellent market for generating outstanding returns. As an aside, some might look at the scale above and see the Dollar Index moving down to values such as “3” or “5” or whatever value and think, ‘well, that can’t develop… that’s not possible.’ To that idea I would reply that currencies are ‘different’ than other assets in that the supply of currency can be potentially unlimited via Central Bank money printing as opposed to the supply of Oil or some other commodity, which in theory even under the worst circumstances, will find a market clearing price. The DJIA, for example, cannot drop below zero. This is not true with an index of a currency which can, and down thru the centuries, has on more than one occasion, fallen to levels below zero. In the case of a currency index, if a currency falls a particularly large distance, over time the index is likely to be reverse split, creating new higher values from which new declines can begin. Our point is that a currency index is a very tricky item and while an index may never be allowed to go into negative territory by its publishers, unlike other asset classes the sovereign currency of a nation can fall for years on end. If anyone doubts this we would suggest looking at some century long charts of currencies like the Japanese Yen and the British Pound where they fell over the course of decades.
It is my view that because every country in the world is, at the moment, desperate for growth and jobs, and that because places like China are already witnessing riots among the masses, that a Dollar decline will be a ‘developing’ phenomena, not a sudden panic or collapse. Over the course of several years a Dollar decline could morph or build into a massive collapse, but we believe that there is a long forward tail on this kind of event. In my work I track a number of currency market indicators covering both short term and long term signals. Over the last few weeks, one of my major trend gauges, a long term Momentum Indicator that I nick-named “Big Mo” has crossed below its long term 200 day moving average.
While there are times when any trend following indicator can be whipsawed, for the most part this gauge gives only one or two signals per year. That means we tend to pay close attention when they develop as once a trend begins in the currency markets, there tends to be a high level of persistency. For US investors there are a number of mutual funds and ETF’s that are now available that can allow investors to take advantage of a falling Dollar. Getting into just a few ideas on how to play a weak Dollar, Powershares has Dollar Bear ETF with a symbol UDN, there is also the Profunds Falling Dollar Fund (FDPIX), the Merk Hard Currency Fund (MERKX), and a host of international bond funds including names like T Rowe Price International Bond (RPIBX), American Century International Bond (BEGBX), Loomis Sayles Global Bond (LSGLX), Templeton International Bond (TBOAX), along with a wide variety of ETF’s from the good folks at Rydex which include individual currency symbols as follows: FXF, FXA, FXC, FXE, FXB, FXM, FXY.
Above: US Dollar Index with key support at the Dec. 2008 and June 2009 lows.
While I believe that the Dollar still has a chance to strengthen in the near term (next few weeks), perhaps the most important key level to be watching over the next few months will be the area of the December 2008 and early June 2009 lows for the Dollar Index which come in as major support at the 78.50 to 79.00 level. Any move below those lows in the weeks and months ahead would have to be viewed as a negative breakdown in the Dollar and would likely add confirmation to the longer range bearish signal just seen on our ‘Big Mo’ gauge. For now, I am neutral on the short term Dollar Index trend, which has been very fragmented with currencies like the Yen trending strongly, while the Euro has remained in a very narrowly confined range. Overall, volatility in currency markets has been coming down, and that tells us to expect larger moves in the months ahead and the beginning of what could be a methodical Dollar decline.
That’s all for now,