Steve SavilleIntermediate-term (6-12 months)
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.
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.
12 July 2006
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