Having spent much of the past 4 years arguing that the dollar was going to fall we have, over the past several months, found ourselves in the uncustomary position of explaining why a lengthy dollar rally was in the offing. With the dollar hitting a new bear-market low last Friday now is a good time to re-visit our bullish intermediate-term outlook, starting with a summary of the bearish case against the dollar.
As far as the coming year is concerned, a VALID bearish case does not revolve around the huge and growing US current account deficit. What the huge US current account deficit does tell us is that the dollar remains extremely over-valued despite its 3-year decline and that long-term investments in US Treasury debt are almost guaranteed to provide poor real returns over the coming 5 years. However, the current-account situation tells us nothing about what the dollar is likely to do over the next 12 months because it is not uncommon for over-valued markets in long-term bearish trends to experience counter-trend rallies lasting 12 months or longer, particularly after they have become extremely oversold. The US stock market is a case in point in that it is probably just as over-valued as the US dollar and yet it is now in the 3rd year of an upward trend. Furthermore, a comparison of the quarterly US current account balance and the US dollar's exchange value over the past 33 years will reveal no consistent relationship between the two as far as the dollar's performance during any given 12-month period is concerned.
The huge and growing US budget deficit is also not a valid reason to be bearish on the dollar because history tells us that there is no consistent inverse correlation between the foreign exchange value of the dollar and the US budget deficit.
So, given that we can eliminate two of the most popular reasons cited for a continuation of the dollar's decline, is it possible to make a valid argument that the dollar will be trading significantly lower in 12 months time than it is today?
The answer is yes; a valid intermediate-term bearish case against the dollar could be made by showing that inflation expectations were likely to rise appreciably over the coming 12 months. Or, to be more accurate, by showing that US inflation expectations were likely to rise at a faster rate than nominal US interest rates. The reason is that changes in REAL interest rates, where the real interest rate is calculated by subtracting the EXPECTED inflation rate from the nominal interest rate, are the main influence on the dollar's trend over any 12-month period.
Now, changes in the expected inflation rate can't be measured but their effects can be observed. For instance, when inflation expectations are rising it is likely that long-term interest rates will be increasing relative to short-term interest rates because the longer the term of the debt the more a lender will want to be compensated for the risk of future currency depreciation.
As such we've included, below, two charts that show how the currency market has been affected by changes in long-term interest rates relative to short-term interest rates.
The first chart shows the performance of the euro over the past 4 years versus the performance of the TYX/IRX ratio (the 30-year T-Bond yield divided by the 13-week T-Bill yield), with the charts offset by about 14 months to account for the currency market's delayed reaction to the widening of the US yield-spread that began during the final quarter of 2000. Note, in particular, that the euro stopped falling once the US yield-spread began trending higher but it wasn't until after the yield-spread had been rising for about 14 months that the euro embarked on a strong upward trend. Also, note that if there is a similar delay at the completion of this trend as there was at its beginning then the euro will remain reasonably firm until early-2005 and won't begin to trend lower in earnest until the second quarter of 2005.
The second chart shows the performance of the euro over the past 12 months versus the performance of the TYX/FVX ratio (the 30-year T-Bond yield divided by the 5-year T-Note yield), with the charts offset by about one month. Note that there was a strong positive correlation between the two markets until September-October of this year, at which point the euro began to accelerate higher while the TYX/FVX began to decline. This recent divergence between the two markets suggests that either we are seeing a speculative blow-off in the euro which is not supported by the underlying fundamentals or that we are about to see a surge in 30-year interest rates RELATIVE TO 5-year interest rates to bring TYX/FVX into line with the currency market. Our guess is that it will turn out to be the former.
To sum up, the points we've just tried to make are:
a) Arguments to the effect that the dollar will continue to fall over the coming 12 months BECAUSE OF the US current account deficit will look right as long as the dollar remains in a short-term downtrend, but are seriously flawed.
b) The US$ is in the final blow-off stage of the decline that began between the final quarter of 2000 and the first quarter of 2002.
c) It's possible that the ultimate low for the dollar won't occur until the first quarter of 2005 and that a strong upward trend won't begin until the second quarter of 2005, but the dollar's downside potential from here is minimal UNLESS inflation expectations begin to surge.
Our view, in a nutshell, is that the Dollar Index will be trading at a much higher level in 12 months time than it is today. We stress, though, that right now there is no evidence that the dollar's short-term downward trend has ended. In particular, an end to the short-term downward trend should become evident in the performances of gold and gold stocks before it becomes evident in the currency market, and at this stage there are no signs that the bullish trends in gold and gold stocks have come to an end. For now, therefore, we remain short-term BEARISH and intermediate-term BULLISH on the US$.