The Coming US Dollar Rally

The Coming US Dollar Rally

For the best part of the last 2500 years the world has had one national currency that has played a dominant, global role and acted as a ‘reserve’ currency. Starting with the silver drachma in ancient Athens, as the empire decayed and lost power the status of ‘holder of the reserve currency’ was passed onto the new dominant empire or country, firstly to the Roman Empire and then the Byzantine empire, the Arab world, then Florence, Venice, the Netherlands, Great Britain and finally since about 1914 the US dollar.

 Currently the US dollar is way out in front as the most dominant currency on the planet, making up 62% of all foreign exchange reserves held by the world’s Central Banks, and acting as the medium of exchange for the overwhelming majority of international transactions.

A number of factors have conspired to substantially weaken the dollar since its 2001 high, including the running of large trade deficits by the US government, the poor long term outlook for the US, and the impending ‘car-crash’ from its huge and expanding debt burden. This dollar weakness has led to much discussion as to whether it will be able to retain its status as the world’s reserve currency, or will a new currency or basket of currencies take over the role at some point.

Another factor stoking the debate is the ongoing impact of the US Federal Reserve’s quantitative easing (QE) policy on the value of the dollar. According to normal market theory this should lead to further dollar weakness, as whenever you print more of a particular currency the price of it should fall in comparison to other currencies. However, that presupposes a simplistic linear relationship, and what we have currently is anything but linear.

I have mentioned in previous posts that unlike the majority of us that can choose to take our assets out of the financial markets when the need arises (by buying property, precious metals or some other tangible asset), the pool of money managed by the ‘professionals’ is simply too large to have that as an option. As a result they are locked into the game, constantly searching for the best relative investment in the best relative currency– in their world the least bad investment is the best investment!

When looking at the alternatives to the US dollar the list is quite short, there are only two that meet the criteria to serve as a truly global currency, the euro and the yen. Currently the eurozone is in total disarray, with its financial woes getting worse and no political will to address them. Money is being driven out of the region into US dollars in search of a safe haven, and the tensions are building to a flash point. Like a powder- keg finding a spark, the end game will be spectacular and result in a much lower euro, or no euro at all. In terms of Japan, they have committed to QE on steroids in an all out attempt to stimulate their economy into recovery, one of the major effects of which has been to trigger a collapse in the value of the yen, as yen denominated assets are sold and recycled into US dollars.

So although the long term outlook for the US dollar doesn’t look good, in the near term it still looks a whole lot better than the only other viable alternatives. Truly, in the land of the blind the one-eyed man is king!

While both of these ongoing events are creating a steady and increasing flow of money into US dollars, there is one other situation unfolding that will likely act as the catalyst to drive the dollar substantially higher. Over the last few years many countries and businesses alike have chosen to borrow in US dollars rather than their domestic currency due to its perceived safety and extremely low interest rates. As I explained in my last post http://kiwiblackers.blogspot.co.nz/2013/10/the-greatest-bubble-on-earth.html the era of low interest rates has come to an end, and as interest rates rise it will make the US dollar increasingly attractive relative to its competitors. Eventually these borrowers will be faced with increasing debt servicing costs and a debt that is increasing in value relative to their domestic currency, at this point there will be a scramble to buy dollars in order to pay back the debt, and when everyone heads for the exits at the same time it can get messy.

These two things combined - the current set-up in the US dollar and the impending increase in interest rates are what I believe sets the scene for a violent rally to occur over the next couple of years.

 Now lets turn our attention to the technical picture and see if it corroborates the fundamental outlook.

When trying to ascertain the US dollar’s relative strength or weakness we could just look at it compared to its cross rates with other currencies such as usd/euro, usd/yen, usd/gbp or usd/nzd. However, these only give us a picture of the relative dynamic between the two currencies not the market as a whole, although by looking at a number of crosses we would be able to discern if there is a general trend emerging. Fortunately there is a simpler way to gauge its performance using a basket of currencies called the US Dollar Index (USDX):

Investpedia explains the index thus:

‘Currently, this index is calculated by factoring in the exchange rates of six major world currencies: the euro, Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc. This index started in 1973 with a base of 100 and is relative to this base. This means that a value of 120 would suggest that the U.S. dollar experienced a 20% increase in value over the time period.’  

Using the USDX gives us a great overview of the US dollar using only one chart, and below we can see how it has performed from 1999 to the present day.

Here we can see the collapse in the dollar from 2001 through to the 2008 low. Since then it has chopped around within a fairly large trading range, although since 2012 volatility has reduced and this is often a precursor  to a big move. Also the longer something has traded within a range, the more violent the move when the breakout finally occurs.

If this plays out as I think likely, it will create some major problems for the global eonomy:

• The increased volatility in foreign exchange markets will make it harder for corporates to transact business, especially impacting their ability to hedge their currency exposure.
• This US dollar squeeze will result in substantial losses for those that have US denominated loans.
• Importers will have to cope with rising prices as the dollar value increases, and this will in turn lead to imported inflation.
• Whilst weak local currencies might seem like good news to global exporters initially, a rising US dollar will likely stop any commodity boom in its tracks, and as already stated, the general disruption, undermining of confidence and increased volatility will all work to reduce global trade.

 

To conclude, I believe that any talk of the US dollar losing its reserve currency status is very premature, as the next few years will only cement its position as the undisputed number one currency in the world. However history does teach us that no matter how big and powerful an empire is, at some stage it will roll over into decline and the benefit of having the world’s reserve currency will be lost. 

That is a crisis for another day, let's hope we can cope with he one staring us in the face.