A bubble in the Dollar was created in 1971 when the Government ended the gold standard. At that time, the Dollar lost its intrinsic value and has been in a bear market ever since. As a result, the Dollar's purchasing power has steadily eroded despite experiencing a number of bear market rallies (Figure 1 - Points 1, 3 and 5). When Dollar bear market rallies occur, people lose sight of the ongoing bear market, and even go so far as to believe that the Dollar is a safe haven. This misperception is not surprising given that bear market rallies create a sense of calm for investors, setting the stage for even greater losses when the bear market resumes. Ultimately, the Dollar bear market will come to an end when most people have suffered severe losses on their Dollar denominated assets and when there is a feeling of despair. We believe that this pivotal stage in the Dollar bear market is nearing.
Figure 1. Trade Weighted Exchange Index of the US Dollar (Broader Than the Dollar Index)
Source: St. Louis Federal Reserve
Figure 1 shows the trade weighted exchange index of the US Dollar - a classic chart of a bursting bubble. (Even though the chart compares the US Dollar with other non-gold backed currencies, its role as the world's reserve currency has transformed it into an asset because of central bank ownership). Point 1 is the parabolic "blow-off top". Additionally, there have been a number of bear market rallies during the long unwinding of the bubble. The peak of each rally (Point 3 and Point 5) had a lower high than the previous top. Following each peak, a lower low was reached. Market technicians use the phrase "lower highs and lower lows" when referring to this decidedly bearish pattern. Also, each bear market rally is shorter in duration than the previous rally including the Dollar rally of 2008, which peaked in March 2009. The index appears close to breaking to new historic lows.
Figure 2. Current S&P 500 vs. The Average of the Past Three Long-Term Bear Markets
Source: Barry Bannister, Stifel Nicolaus
Figure 2 is a chart by Barry Bannister, of Stifel Nicolaus, that compares the average path of three secular stock bear markets (red line) with the path of the current stock bear market that began in 2000 (blue line). Although the blue line shows that stocks are in a secular bear market, it is important to note that the chart of the Dollar in Figure 1 parallels the bear market pattern (the red line) in Figure 2. In light of this, the Dollar appears to be at Point 5 of the typical bear market pattern, and thus, would be on the way to another move lower (discussed later in this commentary).
The Dollar's Background
In the 1960s, the US Government employed a "Guns and Butter" fiscal policy to fund both military and social programs. Without the tax revenue to support these programs, the government began to print new Dollars despite being on the gold standard. The consequence of this policy was that foreigners began to exchange their Dollars for gold. To maintain the government's spending agenda, and also to halt the depletion of the country's gold reserves, it was necessary for President Nixon to end the convertibility of Dollars to gold. Today, excessive government spending and the geopolitical environment are considered to have been the key drivers of inflation in the 1970s, whereas the predominant driver of that period's inflation was the Dollar no longer being backed by gold. Because investors knew that the Dollar had no intrinsic value, they sold and shorted the Dollar to buy commodities as a way to preserve their purchasing power. The investment into physical assets created the price inflation experienced during the 1970s. Had President Nixon instead controlled spending in order to maintain the gold standard, the 1970s would not have been as inflationary.
Paul Volcker is famous for fighting the inflation of the 1970s by steadily raising interest rates to 20% despite the US economy being weak with high unemployment. When he took office, investors were positioned to profit from a falling Dollar and rising commodities. Therefore, investors were caught off-guard when Volcker raised interest rates, leading to such a substantial short-squeeze in the Dollar that the bear market rally ended only after having a "blow-off top" in 1985 (Figure 1, Point 1). Thus, while Volcker is known for fighting inflation, he really should be known for creating a massive short-squeeze in the Dollar. Many people believe that Volcker was forced to raise interest rates to levels that today are unimaginable solely because of the existence of high inflation. However, we believe that Volcker's primary goal was to create the perception that the Dollar had intrinsic value, and thereby, erase the memory of the gold standard. Raising interest rates temporarily accomplished his goal because the Dollar continued to rise through 1985 despite interest rates peaking in 1981. (Anecdotally, the gold standard was mentioned in the opening scene of the 1987 movie Wall Street, a veteran broker says, "The country's going to hell faster than when that son of a ***** Roosevelt was in charge. Too much cheap money sloshing around the world. Worst mistake we ever made was letting Nixon get off the gold standard.")
The Dollar Bubble Explains the United States' Transition to an Asset-Based Economy
The US economy is currently known as an asset-based economy, which is an economy driven by asset price appreciation and excessive spending rather than by production and saving. However, the American economy was not always structured this way. We believe the US economy transformed to an asset-based economy as a result of the gold standard ending. With the Dollar no longer anchored by a real asset, the Dollar's purchasing power was set to perpetually decline (history has proven that fiat currencies ultimately lose all of their purchasing power). Yet, even though most people have been unaware of the ongoing devaluation of the Dollar, consumers and investors have been able to benefit from the asset-based economy by borrowing money. Specifically, consumers have taken on debt to buy cars and houses because the real value of their debt declines as the Dollar's value falls. Investors have also used leverage in order to boost returns, as they knew that over time investments must rise in Dollar terms. The initial impact of increased consumer and investor debt for the United States' economy was strong growth. This growth created a positive feedback loop in which investors bought stocks and bonds, driving interest rates lower and leading to cheaper credit for consumers to buy more goods. Therefore, it is no coincidence that the US has seen an explosion in debt outstanding since the end of the gold standard and, even more so, after the Dollar bubble peak in 1985 (Figure 3). However, had the US remained on the gold standard, the US economy would not have been driven by asset prices, and therefore, credit market growth would have been contained.
Figure 3. Household Credit Market Debt Outstanding
Source: St. Louis Federal Reserve
Dollar Bear Market Rallies Ignite Asset Bubbles
Given that the US is an asset-based economy dependent upon a declining Dollar, the economy faces headwinds when the Dollar has bear market rallies. As a result, the Federal Reserve has focused its policy on combating Dollar bear market rallies by initiating Dollar devaluation programs, such as, cutting interest rates and flooding the system with liquidity. These actions have created asset bubbles.
For example, Figure 1 shows that the Dollar steadily fell for ten years through 1995, even though a recession and a war had occurred. That trend meant that many investors and companies were fully geared to benefit from a Dollar that would fall and from asset prices that would rise. As often happens when a trade is crowded, a short-squeeze in the Dollar began in 1995 and lasted through 2002. Knowing that a Dollar rally was problematic for an asset-based economy, Alan Greenspan kept interest rates low and flooded the system with money despite his 1996 view that the stock market demonstrated "irrational exuberance." The NASDAQ bubble was created as a result of such loose monetary policy. Although there were other factors contributing to the rising Dollar (currency pegs and the Asian Financial Crisis) and to loose monetary policy (Long-Term Capital Management and Y2K), it appears that the bear-market rally in the Dollar had the biggest influence on the creation of the stock market bubble because it enabled Greenspan to keep interest rates too low for too long. If the Dollar had continued its bear market descent instead of rallying, tighter monetary policies by the Federal Reserve would have been required, and the inevitable asset bubble would have never been formed.
The end of the Dollar bear market rally in 2002 coincided with the Federal Reserve Funds rate at 1%. The Federal Reserve had to use significant firepower to force the Dollar downward because so many investors were positioned to profit from a declining Dollar. At the time, a 1% interest rate was the lowest the modern Federal Reserve had employed. Such an ultra-low interest rate allowed the Dollar bear market to resume and to reach fresh new lows during 2003-2007 (Figure 1, Point 4). The continuation of the long-term Dollar bear market led to even larger bets against the Dollar and to higher asset prices. Instead of a stock bubble forming, a bubble formed in housing. As with all bubbles, home prices rose too high and the Dollar became oversold. This led to an unwinding of both trends - now known as the 2008 deleveraging.
2008 Deleveraging
The cause and the effects of the 2008 deleveraging are misunderstood. The well known collapse of the housing bubble has fostered the general belief that falling asset prices led to a rising Dollar, and further, that the system would not have imploded if not for housing speculation and poorly underwritten toxic assets. However, those speculative bets were only made because of the long-term decline of the Dollar. Figure 1, Point 4 shows that the Dollar reached a new bear market low in 2008 even though the Federal Reserve had been raising interest rates. Yet, after a delayed reaction, the Dollar eventually began to rise. The Dollar's rally was quite small in size and duration during the 2008 deleveraging compared to previous Dollar bear market rallies, even though it seemed extraordinary at the time (Figure 1, Point 5). As the Dollar rose, the stage was set for significant problems in asset markets. It was the bear market rally in the Dollar that sent markets into a tailspin - the rising Dollar was the cause, not the effect, of asset price declines.
The bear market rally in the Dollar enabled the Federal Reserve to prevent asset markets from further collapsing by devaluing the Dollar (printing money to buy private assets, guaranteeing loans, TARP, etc.). The Federal Reserve was only able to begin these programs because the Dollar was rising. At the time, people mistakenly believed that the Dollar was rising because it was a safe haven currency. The Dollar was not a safe haven because without Federal Reserve intervention (in other words, Dollar devaluation) the US economy would have completely collapsed, which would have ultimately been negative for the Dollar. In that scenario, GDP would have imploded as a result of debts defaulting, unemployment soaring, and banks becoming insolvent. Further, tax revenue would have vanished and the Government's deficit would have increased. Upon recognition that the US government debt could not be supported by tax revenue, a currency crisis would have ensued, and the Dollar would have fallen. Therefore, the Dollar's rise should only be viewed in the context of a bear market rally instead of as a safe haven because, with or without Federal Reserve action, the Dollar would have eventually resumed its bear market decline.
Despair is Near
Prior to despair, investors tend to pursue the very trend that will eventually hurt them. Currently, investors are embracing risk by buying stocks and other risk-assets based on the rationale that the Dollar will remain weak or even weaken further. However, when the Dollar's decline becomes disorderly, government bond prices will fall (higher interest rates), and risk will be avoided.
We believe that, following last year's bear market rally in the Dollar (Point 5, in Figure 1), the Dollar is on the cusp of a disorderly move lower that will lead to despair. Although investors are embracing a weak Dollar, central banks are beginning to question it as a reserve currency and are diversifying into gold. For example, India, Sri Lanka, and Mauritius recently bought gold from the International Monetary Fund. Further, related to gold, Richard Russell wrote in his October 21st edition of "Dow Theory":
Gold has closed higher for nine consecutive years. So far, it's been a great and huge bull market. All great bull markets come in three psychological phases. The first phase is the accumulation phase, during which sophisticated and value-oriented investors pick up what is generally being ignored. We saw that phase in gold back around 1999 and 2000. At that time I wrote that many gold stocks were selling so cheaply that they could be bought, "put away" and held as perpetual warrants just in case gold would "some day head higher."
The second phase of the gold bull market came around 2005 with gold priced around $400 an ounce. The second phase saw many old-time gold fans return and buy gold. They harbored memories of the 1970s and suspected that gold might be in another bull market. I believe the second phase of the great gold bull market is close to ending.
What's next? I've never seen a great bull market that didn't end with a third speculative phase. Often those who buy in the third phase will make as much in a shorter period of time as those who waited patiently through the entire first and second phase.
The second phase often ends with a severe secondary reaction that turns most people bearish on the item. We saw that in gold during the brutal correction that started in February 2009, a correction that ended when gold climbed decisively above $1000 an ounce in September.
Will there be a third speculative phase for gold? I believe so. If I had to guess, I think we'll see it start some time next year. It should begin if or when gold closes above 1100.
Conclusion
The key to understanding the future path of the US economy and the Dollar is to understand the origin of the current situation - Nixon's suspension of the gold standard created the Dollar bear market and transformed the US into an asset-based economy. Since then, the moves in the Dollar bear market have determined whether the US would grow, recede or become an asset bubble. Despite the Dollar's continuous loss of purchasing power, most people still do not realize that the Dollar continues to be in a 38-year bear market. Ultimately, the market will lose faith in the Dollar, and it will then be clear that the asset-based economy was not viable.
