Get Ready for a Dollar Bull Market

Get ready for a multi-year bull market in the U.S. dollar.

Yes, you heard that right.

No statement about investing right now could feel more wrong. And this is why it's probably time to start swimming against the tide.

First, I'll make a mundane case based on timing. Consider the following chart:

Since the Bretton Woods monetary system started breaking down under the strains of the Vietnam War and Great Society spending, there have been three dollar bear markets, each lasting roughly 10 years: 1968 to 1978, 1985 to 1995 and the current dollar bear market, which started in February of 2002. Currently the dollar is right against the lower bound of its long term trading channel.

You might say that the major currency index is no longer relevant due to the rise of emerging markets. Here is the broad dollar index (which incorporates all currencies on a trade-weighted basis) in real terms (adjusting for differences in inflation):

Not much difference in the timing of the bull and bear markets. Against the broad basket, the dollar has punched below the lower bound of its long term trading range, which means it might just be ready for a snap-back.

But things are so much worse now, aren't they?

In the mid-to-late 1970s, we experienced the loss of a major war and the resignation of a president, soaring inflation and commodity prices, union militancy, provocations by tin pot despots in the Middle East, years of bear markets in both stocks and bonds, weak leadership at the Fed and a general sense of American decline. Plus you had polyester leisure suits and disco.

In the early-to-mid 1990s, we were experiencing the "hollowing out" of American manufacturing and "downsizing" of white collar jobs, years of a brutal bear market in real estate, Japan was eating our lunch, years of large fiscal deficits, the aftermath of a major banking crisis and credit crunch that had followed a boom in high yield and real estate debt, a divided government with Congress controlled by firebrand conservatives that had forced a shut down of the Federal government and a general sense of American decline. At least we had flannel shirts and grunge rock…better than the late 1970s.

Hmm…for the most part these periods of time sound pretty similar to today.

There are major differences, of course. For example the transition to the dollar bull market involved a horrible recession in the early 1980s, while in the mid-1990s the transition was relatively smooth (in the U.S. anyway).

So what happens in a dollar bull market?

  • Real interest rates rise. This might come from a rise in short term interest rates or a shift to falling prices or very low inflation (or both).
  • US technology is hot. Leading edge technology attracts a lot of investment. The great venture capital bull markets coincided with the dollar bull markets of the early 1980s and late 1990s.
  • US business investment rises. Higher real interest rates attract investment capital back into the US, which flows into software and business equipment.
  • Emerging markets crash. It is no coincidence that the great emerging markets crises occurred in the early 1980s and late 1990s. The strong dollar draws investment dollars away from emerging markets and back to the US. This occurs after 10 years of an emerging market bull market during which untold unbalances build up. Would you really be surprised to find out that much of China's growth has been built on a mirage of cheap credit and wasteful infrastructure spending?
  • Commodities and farm prices crash. A rising dollar is a net negative for commodity prices (which are priced in dollars). Plus, it usually turns out that much of a commodity bull market is built on financial speculation, which flees once it becomes clear that momentum has shifted.
  • Large cap outperforms small cap. The long-awaited rotation from small cap to large cap and from value to growth might finally occur.

I am assuming that the transition to a dollar bull market will take a year or more. My plan is to gradually start moving to underweight in commodities, emerging market stocks and foreign bonds. As the Fed transitions from accommodating to neutral or restrictive, or if there is an inflation or financial crisis in emerging markets like China, there could easily be a major bear market US equities. I will wait to see how the market handles the transition in monetary policy before moving to overweight in large cap US stocks. There is also a dollar bull ETF, the Powershares DB USD Bull ETF (ticker: UUP), for those that want to get more aggressive.

I remember people yelling at me for being an idiot when I was buying gold and silver back in 2002. People argue vehemently against me now. I must be on to something.

I am not a financial adviser and write these articles purely for my own amusement. Please consult your financial adviser before acting on any of the recommendations posted here.

Inflation is not a problem (yet)

I've been saying for a while that the dominant underlying economic force in the United States is that of deflation. If left to its own devices the US economy would collapse into a deflationary depression and take the world economy with it. Of course, the economy has famously NOT been left to its own devices. The federal government has invested $750 billion in the banking system, issued a $700 billion stimulus package AND forecast deficits of 5-10% of GDP as far as the eye can see. The Fed has expanded its balance sheet by $1.25 trillion since the collapse of Lehman Brothers, with plans to expand it even more by buying long term treasury, mortgage and asset-backed debt. The Fed Funds rate has been set at 0% to 0.25%, allowing the banking system to borrow from the Fed at very low short term rates, while risky debt is yielding much higher rates, fattening bank profits (before asset write-downs).

We are in uncharted economic waters, and in a system as complex as the world economy, it is hard to separate signal from noise in terms of what effects our policies will have and how they get transmitted through the economy. In economics class, most rules start with the assumption "all other things being equal", which in the real world is never true. In fact, the economy is in a constant state of disequilibrium, but with a powerful force that seeks to restore equilibrium in some things while creating more disequilibrium in others. In my view, the easiest way to make money is to spot the disequilibrium that faces the path of least resistance to be corrected and to bet on that correction.

The correction occurring right now is the massive unwinding of the inflationary housing bubble. The unwinding of a debt-fuelled inflationary bubble comes in the form of debt deflation. Because an unchecked debt deflation is what caused the Great Depression, today's economists have been taught to fight debt deflation at all costs. Thus we are recapitalizing the banks, printing money like mad and engaging in deficit spending. In other words, we are fighting a deflation specific to real estate (and to a lesser extent, LBOs) with a generalized inflation. The inflationary policies are alarming to many, even prompting a recent round of speculation that the US may lose its "AAA" credit rating. So far, however, market signals are telling us that the greatest set of inflationary policies ever devised has so far only created "reflation", or the undoing of deflation, and are not yet signaling high inflation. The Fed and Congress will need to be vigilant about withdrawing this inflationary stimulus if the market signals do start pointing to inflation, however. The signals I watch are the TIPS spread, the Treasury yield curve, the value of the dollar and the price of gold.

The TIPS spread

The easiest way to look at the market's inflation expectations is with the TIPS spread, or the spread between the yield on a Treasury Inflation Protected Security and a nominal Treasury bond.

As of Memorial Day 2009, the nominal 5-year bond yield is 2.14%, the 10-year is 3.37% and the 30-year is 4.32%. The 5-year TIPS yield is 1.34%, the 10-year is 1.63% and the 30-year is 2.12%. That means the 5-year market inflation assumption is 0.8%, the 10-year assumption is 1.74% and the 30-year is 2.2%. Since the Fed's implicit inflation target is 2% and in historical practice it has been 2.5%, inflation would appear to be well in hand.

However, those numbers assume that inflation averages 0.8% for the next 5 years, jumps to 2.7% for years 5-10, and then settles back down to 2.4% for years 10-30. Not terrible, but probably a pretty good assumption that inflation will accelerate after the eventual recovery.

Treasury Bond Yields

If you assume the Fed has a long term goal of 2% inflation, the equilibrium treasury yield curve would look like a Fed Funds rate of 2.75%, a two-year of 3%, a five-year of 3.5%, a 10-year of 4% and a 30-year of 4.5%. I put a band of 25 basis points (0.25%) around the Fed Funds and the two-year and a 50 basis point (0.5%) band around the 5-30 years, just to account for the fact that this isn't an exact science. (I use 2.75% or the Fed Funds rate, because that leaves a zero percent return after inflation and taxes, which is all you should expect for holding riskless cash.) By this analysis, the Fed Funds rate, the 2-year (at 0.85%) and the 5 year are well below their equilibrium rates, the 10-year is approaching its equilibrium range and the 30-year is in its equilibrium range.

The current yield curve implies that inflation and the Fed Funds rate will be low for several years, but that reflation will be successful but controlled and that is what's being reflected in the 10-year and 30-year spreads.

The Dollar

One problem with using treasury yields for a market indicator is that the short end of the curve is always manipulated by the Fed (and the Fed sometimes gets it wrong) and recently the Fed has even been manipulating the long end of the curve by buying Treasuries. If rates are manipulated too low by the Fed "monetizing" the Federal debt, the pressure would be relieved in the form of a weaker dollar.

When deflation is a problem, people hoard dollars to stay liquid and the dollar rises. In reflation, the dollar is pushed back into its equilibrium trading range. In inflation, the dollar bumps against the bottom of its trading range, as it did as recently as early 2008.

Nominal Major Currencies Index:

The dollar, relative to other major currencies, has been on a mild downward path (less than 1% per year) since we dropped the gold standard in 1973, if we exclude the two dollar bubbles of the mid 1980s and the late 1990s. Given that the original fixed currency values under the gold standard (Bretton Woods dollar standard, really) were set after World War II, when the US had most of the world's gold and the only major economy not devastated by the war, I'd actually say that's not a bad performance for the dollar.

In my view the equilibrium value of the major currency dollar index is between 84 and 70, with a mid-point of 77. It is currently at 79.5. While the dollar has fallen a bit in the last few weeks, it is still near the high end of its range.

Real Broad Dollar Index:

Against all currencies (in real terms), including emerging market currencies, the dollar as of the end of April was at 96, just above its long term equilibrium range of 85-95. Given the action so far in May, it's probably now in the range, but close to the top of the range. This means people are no longer hoarding dollars in a deflationary manner, but it also means inflation is not out of control.

Gold and commodities

Of course nearly every country in the world is printing money and running large deficits to get through this crisis. When all currencies are being inflated, they can all drop together, even while the dollar appears to be in its trading range. When all currencies are weak, the price of gold and other hard commodities rise as investors lose faith in paper assets and move their money to assets that protect the long run value of their hard earned savings. Gold, while it pays no interest, will at least in the long term (since the dawn of man, really) serve as a store of value as long as it's not bought during a speculative fervor.

Gold price in dollars:

The value of the dollar has declined from 1/35th of an ounce of gold during the Depression to around 1/150th of an ounce in the mid 1970s, to an average of about 1/375th from the mid-1980s to the mid-1990s to about 1/900th of an ounce today. That means the dollar today is worth just 3.9% of what it was during the Depression and World War II.

The price of gold rose from $260 an ounce in 2001, when the dollar was strong and real interest rates were high, to $1000 per ounce during the recent inflationary fervor in early 2008. Had severe deflation taken hold, I would have expected gold to fall back to under $600 per ounce. Instead, it has stayed high (generally in the $850 to $950 per ounce range), and it is currently at $955. If gold remains under $1,000 per ounce, renewed inflation (beyond what the market anticipated before the bubble burst) is probably not a problem.

Another way to look at commodities is the value of a commodity relative to gold. The "normal" price of oil, for example, during the 1980s and 1990s, was $20 per barrel. During that period the normal price of gold was $375 per ounce. If the new normal price of gold is $900/oz, the new normal price of oil is $48 per barrel. Today it is at $60…probably overvalued at bit, but not signaling massive inflation.

Conclusion

The market signals are not currently pointing to inflations' being a problem for the US. That said, the Fed must be vigilant about moving rates to equilibrium or above when the signals start pointing to an inflation problem. The signals pointed to inflation in 2004-2008 and the Fed was slow to respond. Now the Federal government is in on the action as well. Congress will need to rein in it spending when the time is right. Unfortunately, Congress' track record has not always been strong in that regard.