to HomePosted Tuesday, November 30, 2010
The Dollar Reverses...but for How Long?
For many weeks, the big story in the currency markets was the U.S. dollar. Exacerbated by the expectations of new quantitative easing on the part of the Federal Reserve, the greenback's steady decline was threatening to turn into a rout. As I have previously pointed out, this particular decline--contrary to the more beneficial one that helped the world temporarily avoid disaster following the late 2008 financial panic--was serving as the cause of dramatically increased trade and related tensions.
But as if someone had flipped a switch, things over the last few weeks have completely reversed themselves. After the initial added bloodletting for the dollar following the formal QE-2 announcement, the U.S. dollar has done an about-face and surged higher. Though they have bent somewhat, risk assets--stocks, junk bonds and most commodities--have not yet broken. I still tend to believe, though, that a sharper break is coming. Even if it is not caused by the U.S. dollar heading higher still, such breaks will likely come as China and other predominantly Asian developing market nations ratchet up their efforts to fight off inflation (largely exported to them by the Fed.) In the November issue of The National Investor that is about to be released, subscribers will read more about that; and how we will seek to profitably play both sides of the market based on those efforts.
But back to the dollar. Let's first describe the key factors that have caused this huge reversal in the currency market:
The dollar was dramatically oversold. Paraphrasing what I wrote in the October issue, when everybody and his dog is on one side of a trade, you don't want to be there! Such was the case as short positions in the dollar reached their highest level in some three years about a month ago. As things began to turn, traders have been predictably forced to reverse these bets.
The euro's swoon. It's been almost as if Europe's common currency were jealous of all of the (largely negative) attention that the dollar was receiving. The euro insisted, "Hey - What about me!? I'm a basket case, too!"
So the euro aggressively snatched back from the dollar the chief focus--and trepidation--of currency traders. And in the way in which the most recent euro zone crisis in Ireland has been bandaged over, the euro zone's leaders have virtually guaranteed that their currency will not be more desirable than the U.S. dollar again anytime soon. Indeed--as I explain at some length in the upcoming November issue--it is probable that the European Central Bank will be outdoing even the Federal Reserve in the quantitative easing department!
The euro has crashed in mere days down through a series of technical support levels. The most recent of those was yesterday, when it fell below its 200-day moving average for the first time in several months. Worse is yet to come.
The size of QE-2. You know that one of the last things I can be accused of being is a defender of either unscriptural banking generally or the Fed in particular. But putting things into some perspective, it must be remembered that the $600 billion or so that the Fed intends to add to its balance sheet between now and next June is actually much more modest in size and scope than was QE-1, which saw the better part of $1.5 trillion added. Further, other developments that I predicted back in the October issue have also come to pass; they have cast some doubt on whether even the full $600 billion will end up being allocated (more on this also in the November issue!)
LIBOR begins to creep up. Short-term LIBOR rates--which, among other things, serve as a gauge of how confident banks and other financial institutions are in lending short-term money--have begun creeping up again after a few months of being dormant. The modest increase so far is not yet a cause for alarm; but it bears watching. We need to remember that increasing LIBOR rates were a key predictor earlier this year of the accelerating troubles for the euro specifically and the markets generally.
At the moment, the moves in the dollar and in the euro are overdone technically on a short-term basis. It is probable that the coming several days will provide some opportunity for both to consolidate their respective moves. What we all want to know is whether or not--after a pause, consolidation or whatever we get--these recent trends will be continued.
If the dollar continues an upward trajectory that ends up rivaling that of late 2009 through mid-2010, it will be dependent on factors in addition to its benefiting from Europe's woes. The following three factors would be most likely to add to the greenback's upward bias:
Bolder Chinese and other action to cool inflation. I have much more to say about this subject in our current issue also; but for now allow me to repeat a hypothetical question that some too-smug investors in (primarily) commodities fail to ask themselves:
What is in China's interests?
If I was a key policymaker in that country, I would be doing all in my power right now to strengthen the value of the U.S. dollar as well as weaken commodity prices. As has been the case at different periods in the past, this would allow me to stock up even more on resources that will be used in future years at relatively lower prices; and with a temporarily higher dollar to even better pay for them.
International tensions. In the grand scheme of things, North Korea's recent firing on an inhabited island that they claim is theirs is a sideshow. As one geopolitical analyst we subscribe to puts it, North Korea is but the spoiled stepchild of China. China's objective in all of this will be to have a united Korea one of these days that will end up being a big economic advantage to China in the end. So the odds are quite long against the recent hostilities being allowed to escalate.
Iran is a different matter. 2011 will be much more about the headaches being caused by it. If the fears and saber rattling become sufficiently acute, the dollar will benefit as a perceived safe haven.
Can America contain its own problems? Though I seriously doubt they will prove any more lasting than the so-called "green shoots" of earlier this year, the perception is again becoming that--if only in relative terms--the U.S. economy has regained slightly more vigor. America's most pressing problems are presently seen as less bad than those in Europe. To the extent this all continues, we will see a repeat of the environment of earlier this year (sans the BIG hiccup of the "Flash Crash.") Back then, I termed it as the "Y2K Phenomenon" when-- as in 1999--pretty much the whole world took refuge in U.S. markets and financial assets.
Most curious to watch will be just how quickly unraveling state and local government finances will force Washington's hand. Though not in a legal sense the same situation as Europe's masters face with their individual nation-states, in a practical and financial sense the U.S. government will similarly be forced into bailing out its protectorates. Once that becomes more real, neither the dollar nor the euro will be wanted by many traders. That will be when--among other things--you'll really see a big move higher in precious metals...
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