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Will This be a Sustained Phase of Dollar Weakness?

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EDITOR NOTE: The dollar index is once again hovering just points above its 2018 lows. Speaking as a technician, if it breaks below the 88.00 range, then it can easily head lower toward its 2012 - 2015 lows at around 80.00. The fundamentals of the dollar weakness, as clearly stated in this Bloomberg article, support this outlook. In other words, we’re looking at a “sustained downtrend” in the dollar. The pressure is not only coming from external factors (such as China) but mainly from internal weaknesses, namely President Biden’s spending and the Fed’s continuous money printing and inflation seeking. The good news is that all of this is bullish for gold and silver. And unless you want to hold on to a shrinking dollar amid rising consumer costs, you might strongly consider hedging your purchasing power through non-CUSIP gold and silver coins and bars. Financially, the only other option you have is monetary decline.

A long weekend is in prospect in the U.S., to end what has been a quiet month on the markets (outside of cryptocurrencies). In such circumstances it’s easy to miss something important. For the last Points of Return in May, here are some trends that might have been too easy to miss.

The Dollar at a Crossroads

Two months ago, the dollar was rallying, and touched its 200-day moving average, suggesting that it was ready to break higher. Technical analysis matters a lot in the foreign exchange markets, and that moment helped traders decide that they weren’t prepared to take it higher. Now the dollar is at another possible parting of the ways. If the currency drops further from here, it sets a new seven-year low, and strengthens the belief that it is now in a secular downturn:

Dollar Weakness

The last big sea change, in late 2014, came as oil tanked amid extreme dissension at the Organization of Petroleum Exporting Countries. As crude is priced in dollars, they tend to move in opposite directions. The recent strengthening of the oil price has contributed to dollar weakness. But it is more about the central argument that has coursed through markets for months: Is inflation really on the way back, and if so will it bring higher rates with it? Increased borrowing costs would tend to attract money into dollar-denominated assets and strengthen the currency. The mini-peak came a couple of months ago when the inflation trade was at its peak and everyone was braced for a repeat of the 2013 “taper tantrum,” when yields shot higher as the Federal Reserve tried to prepare the way for a gradual removal of asset purchases. Since then, the bond market has calmed down somewhat. Kit Juckes of Societe Generale SA suggests that it might be best to assume the tantrum has already happened:

US 10-year yields rose from a low of 1.4% in 2012, to 3% during their tantrum. In this cycle, the rise has been from 0.5% to a high just below 1.8%. That’s comparable in relative terms. The eventual peak in US yields in 2018 was 3.25%. Can’t we accept that the taper tantrum has already happened? The important difference is that in the tantrum cycle, core CPI never got above 2 ½%. A bet on further bond weakness is a bet on inflation proving to be stickier than the Fed can cope with. 

A bet on bond weakness (with higher yields) would also be a bet on a stronger dollar. At present, investors seem reluctant to place such a wager, which could point to protracted dollar weakness.

Another factor is the strength of the recovery in the U.S. It matters whether this is inflationary. It also matters whether the recovery is stronger than in other countries, which at present seems likely. If so, then it is fair to expect the returning U.S. consumer to demand more imports. That would widen the U.S. trade deficit and require net sales of dollars for importing currencies, meaning it would weaken the dollar, all else equal. This chart from Longview Economics Ltd. of London shows the closeness of the relationship:

Dollar Weakness

In the long term, a deepening deficit would help cyclical sectors of the stock market, while the weakening dollar would in itself be inflationary (by increasing the dollar price of imports) That would mean growing inflationary pressure in the U.S., and would tend to prompt capital to go elsewhere. An unbalanced international recovery could end up weakening the dollar. This is Longview Economics’ view:

Our view is that the cyclical/value reflationary sectors of the global stock market will outperform over coming years. That sector rotation should be driven by rising bond yields as markets price in growing inflationary pressures in the US economy. As such, capital will favour non-US markets, and drive a sustained phase of dollar weakness.

Then there is China’s influence. All unnoticed, the Chinese yuan has appreciated significantly, and has now regained all the ground it lost amid the “trade war” tariffs of late 2018. With the exception of a brief period in early 2018, it hasn’t been this strong since the infamous devaluation of August 2015, marked in the chart. With investors increasingly looking to China for the cue while the Western world seems becalmed, further strength for the yuan would translate into broader weakness for the dollar:

Dollar Weakness

Another way to put the relationship between China and the dollar involves the commodity market. When China is booming, demand for raw materials tends to be higher, and so a strong yuan and strong commodity prices tend to go together. Since the 2015 devaluation, the following chart shows that the yuan has very much followed resource prices:

The recent rally in metals is widely regarded as evidence of a strong cyclical recovery. If investors believe in that story, the impact on the Chinese and U.S. currencies is another way in which global reflation could translate into a weaker dollar. 

Will investors have the appetite to take the dollar lower? It looks to be one of the critical questions to answer in June. On balance, we should prepare for a major period of dollar weakness — unless the next raft of data shows that inflation really does take off in the U.S. and forces the Fed into tightening earlier than it wants.

Originally posted on Bloomberg

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