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.

Q3 Market Update: The Fed’s War on Savings

The Federal Reserve recently announced that it would purchase up to $600 billion of US Treasury bonds in a program known as "quantitative easing", which is a fancy way of saying "printing money". This is actually the second bout of quantitative easing since the financial crisis, and thus this round has earned the nickname "QE2". The policy of printing money is a blunt economic instrument, with wide range of consequences, known and unknown. The announcement of the policy has attracted no shortage of critics, from World Bank President Robert Zoellick, to Sarah Palin, to the leaders of Germany, Japan, China and Brazil. All deride it as inflationary currency manipulation.

The Fed's ultimate goal is to prevent a Japan-like malaise of falling prices and shrinking consumption from infecting the United States. With short-term interest rates at zero, the Fed can't lower short-term rates any further. By printing money to buy longer-dated treasury bonds, the Fed accomplishes two things. First, by increasing the supply of money, it decreases the value of the dollar which helps create positive inflation. Second, by reducing interest rates of "risk-free" investments like cash and treasuries to below the rate of inflation, those investments become money-losers in inflation-adjusted terms. The goal is to bribe savers to shift investments from cash and treasuries into "risky" investments like corporate debt, equities and real estate and also into near term consumption of goods and services.

Pushing on a string in the US

There are three major problems with this policy. Americans are unlikely to increase their consumption markedly, given that they are determined to rebuild their savings after years of under-saving. In addition, real estate suffers from a massive debt overhang and isn't likely to truly recover for years. Businesses will gradually increase their investment, but generally act in their own interest and can't be forced into making investments they wouldn't otherwise make. For these reasons, the Fed's war on domestic savings will not likely be successful. In economics parlance, the Fed is "pushing on a string". Instead, we are seeing a shift of savings from investments that have a negative real rate of return (like cash and bonds) and into those that are considered inflation hedges like precious metals and commodities like oil, wheat and cotton.

Taking the fight to China

The second front in the Fed's war on savings is against the biggest saver in the world: the Chinese government. The Chinese government has systematically manipulated the world trade markets by recycling its export earnings into US dollar-denominated assets instead of into US-dollar imports. By mathematical equation, this results in a trade surplus in China and a trade deficit in the US. In the past decade, China has accumulated over $2 trillion of US-dollar reserves. By increasing the supply of US Treasuries and by holding interest rates below the rate of inflation, the US is essentially taxing Chinese savings. The weak dollar also pushes up the currencies of countries that compete with China, not only those of emerging market economies, but also currencies like the Japanese Yen and the Euro. China, Japan, Brazil, Korea, etc. have all been using export promotion policies like currency suppression to enrich themselves at the expense of exporters from the United States. The Fed is finally saying "Two can play at that game".

The current long-term trend of artificially-suppressed interest rates, a weaker dollar and higher commodities will play out until the world cries "uncle!". No one knows when this will happen, but when it does, the current trends will be reversed.

Economic growth ahead

The Fed has clearly learned the lessons of the Great Depression and of Japan. The TARP and the first round of quantitative easing were designed to prevent a second Great Depression, and were successful. QE2 is designed to prevent a repeat of the past two decades of deflationary malaise in Japan from occurring in the United States. If the Fed is determined to prevent deflation, they will. The downside, because there is no "free lunch" in economics, is a weaker currency on a relative basis (next to other paper currencies), and on an absolute basis (relative to precious metals and commodities). The decline in the dollar pushes up the prices of imported consumer goods and commodity products like food and gas, even while overall inflation may be tame. This hurts low-to-middle income Americans most of all.

Fixed Income

Looking at the interest rate complex, we can see that treasury rates are far below their equilibrium levels, with the exception of the 30-year treasury. Treasury Inflation-Protected Securities are showing negative yields right now, which is a sign that investors expect the Fed to be successful at maintaining positive inflation. The 30-year, which is the least manipulated issue on the curve, is expecting inflation to average 2.6% over the next 30 years, which is over the Fed's target range.

Source: Vanguard Funds, Bloomberg Treasury Rate Data,

These rates are even lower than what prevailed at the time of my last post on July 11, 2010 (when I declared that there was not much more fun to be had in the fixed income markets…oh well).

So while the treasury complex is artificially over-priced, risk assets like corporate bonds, high yield bonds, muni bonds and equities are priced at above-equilibrium "spreads" over treasury rates, even if nominal yields are below equilibrium levels. If you are a long-only investor, it would be better to keep your fixed income investments in less-volatile shorter term maturities. If you are the type of investor that can short the appropriate treasury while going long on corporate, high yield and municipal bonds, you can enjoy better-than-equilibrium returns.


The rise in long-term inflation expectations explains the rise in the equity market since July.

Implied market returns



The implied long term return on equities is 2.4 percentage points higher than the yield on the 30-year treasury, versus an equilibrium spread of 2.3 percentage points. (This equilibrium spread is based on an after-tax equilibrium spread of 4.5 percentage points above the after-tax return on the 30-year treasury. Because equities are more tax efficient than treasury debt, the nominal equilibrium spread shrinks to 2.4 percentage points.) Note that I use a lower spread than the 6% or so often used in valuation textbooks.

Equities are a decent buy at this point if you believe that the Federal Reserve's policy of quantitative easing will be successful at increasing long term inflation expectations, weakening the dollar and supporting economic growth. So far the price of the 30-year treasury bond and equities are telling you that the market thinks that quantitative easing will be successful.

The Dollar

The value of the dollar also shows that the market believes that quantitative easing will be successful.

Major Currencies Index (nominal)

Broad Currencies Index (real)


Both measures of the dollar index are trading at the bottom of their long term ranges, which means that further upside in foreign currency trades may be limited.

Gold and commodities


Both gold and commodities reflect the effects of quantitative easing.

On a relative basis, oil and other commodities are cheap relative to gold.

Source:, calculations by

Conclusion: A crowded trade?

In the past week (November 8-12), the QE2 trade has been reversing itself. Treasury yields and the dollar have been rising and gold and stocks have been falling, reflecting a classic "buy the rumor, sell the news" situation. The QE2 rally reflected a liquidity-driven rally, where everything except the dollar (stocks, bonds, commodities, and foreign currencies) goes up, and since November 8, we've had a classic withdrawal of liquidity trade, with everything except the dollar going down. This is different from a crisis trade, during which treasury bonds would also rally.

Possible reasons for the break in the markets this week:

  • European debt – In the past week, we've had the glimmerings of a renewal of the European debt crisis, as the yields on bonds of Ireland, Greece, Spain, etc. have returned to records relative to German bonds. If a renewed sense of fear regarding Europe were driving the markets, then we would see treasuries rallying, which we are not.
  • China slowdown – Another possibility is fear that QE2-induced inflation in emerging markets, particularly China, is forcing them to take unpredictable actions to slow their economies, fight inflation and/or erect capital controls. This is a distinct possibility, although I would expect such a scenario to lead to a decline in the dollar, which we are not seeing.
  • QE2 letdown – The markets may have been disappointed with the size of the QE2 program ("only $600 billion versus $1 trillion or more). This could be true, which would also support the following scenario.
  • Just taking a breather – The markets are just taking a breather after a good run.

The balance of risks tells me that the markets are likely transitioning from a liquidity-driven phase to a phase that will discount moderate-to-strengthening economic growth. Such a scenario would favor equities and commodities and support the spreads of risk assets over treasuries. The valuation level of domestic equities is relatively high, however.

QE2 will continue to drive investors into emerging markets, which will likely to blow a bubble in emerging markets stocks and commodities. I don't think emerging markets stocks are cheap, but the "story" will likely stay favorable for some time.

Action plan

As the current market pullback runs its course, I will likely trim a few of my precious metals (gold and silver) positions and add other commodities (a net neutral change in the commodity weighting for the whole portfolio). I will trim a bit of my foreign bond positions (which I added last quarter) and add foreign stocks. I remain neutral/underweight domestic equities at levels above $1,000 on the S&P 500. I remain neutral on bond duration in the US.

Waiting for "regime change"

I suspect we are in the last phase of "casino capitalism" in the international capital markets. While the leaders of the G-20 couldn't agree to anything last week, it is only a matter of time before the international currency and trade system slams into a wall of nationalism. At that point, international regulation of currencies, trade flows, bank leverage and hedge funds will become widely accepted to save the real economy from the whims of the financial economy. The financial system is meant to serve the real economy, not the other way around. The transition to the new system will be messy, so stay on guard in the meantime. Be conservative in your investment decisions, don't be afraid to hold cash and don't be a hero. I still have a strong suspicion that the best investment opportunity still lies ahead.

I am not a financial advisor, and write these columns for personal enjoyment only. Please consult your own investment advisor before acting on any recommendations you find on the internet.

Q2 Market Update: Sometimes cash is the “least bad” option

The S&P 500 has fallen 9.2% since my last update on April 16. The decline has been driven by a large shift in long-term inflation expectations, which have declined from 2.7% to 2.3% today (as determined by the 30-year spread between treasury rates and 30-year inflation-protected securities, or TIPS). This is consistent with the news coverage surrounding the European debt crisis, which has been raising deflation fears in the markets. As a result, the 10-year treasury yield has fallen from 3.8% to 3.1%. The dollar has risen, gold has been steady and commodities have fallen, all consistent with the global slowdown scenario.


With the decline in the assumed inflation rate, stocks are pricing in a 6.4% long term return, based on long term trend earnings of $58.40.

This return is below the target return of 6.8%. To produce a 6.8% return for today's assumed level of inflation (which coincides with what the Fed targets, so it's a good equilibrium assumption), you would need to see a S&P 500 level of 945.

Fixed Income

There's not much more fun to be had on the fixed income side of the house.

Unfortunately, everything is overvalued with the exception of long term munis, which are roughly fairly priced. The only way to get excited about bonds right now is to have conviction that we're headed into a deflationary double-dip recession.

I don't have that conviction. I'm more in the camp expecting that we'll stumble through a subpar recovery, with the economy weighed down by deleveraging in the consumer and real estate markets. If I had to put new money to work in the US, I would either keep it safe in cash or short term bonds for deployment later or I would buy stocks out of a lack of better options, where we could see a bit of a rebound as people realize the world isn't relapsing into recession.

The dollar

Major currency index – nominal

The dollar has rallied against the Euro and other major currencies recently, trading to the top of its long-term (downward-trending) trading range. This creates an opportunity to cycle some money out of US fixed income (like corporate debt or TIPS) and into foreign stocks and bonds.


I'm not sure what to make of commodities. Commodities, as represented by the CRB futures index, are cheap relative to gold but expensive relative to consumer prices.

For all we know, gold could be overvalued, so I'm not enthusiastic about recommending buying commodities.


Housing prices are still a bit higher than their long-run, inflation-adjusted equilibrium level of about 100. Given how high prices were away from equilibrium during the boom, and that prices and sales are being actively propped up by the government currently, there is a great danger that prices can overshoot to the downside if the market relapses, which it easily could. My hunch is that commercial real estate is in even worse shape than residential.


Outside of taking advantage of the strong dollar to allocate some money into foreign stocks and bonds, I'm at a loss to get excited about any particular asset class. Not a bad time to take some bond profits and build up some cash. Cash may pay zero percent right now, but that's better than losing money.

This column is written purely for the author's pleasure. I am not a financial advisor. Please consult your own financial advisor before acting on any investment recommendations.

Predicting Inflation: Gold versus Bonds

Predicting Inflation

In my most recent market commentary, dated 2/9/10, I discussed how sensitive market prices are to future inflation expectations. To the extent that you can discern whether the market expectations for future inflation is too high or too low, you should be able to beat the market by using tactical asset allocation. During the market chaos of early 2009, long run inflation expectations had fallen to 1.0%. If you were able to predict that the federal reflation efforts would be successful (at least in the short term) and that market inflation expectations would rise to where they are today (2.6%), you could have caught the market bottom and benefitted from the 70%+ run up in the S&P since that time. I was too pessimistic and missed most of the run-up.

In normal times, the market appears to view 2.5% as the natural long-term inflation rate. The Fed claims to view 1.5-2.0% as its desired inflation rate. In my market equilibrium model, I have used 2.25%, but have tended to favor a range of +/- 0.25% with the acknowledgement that market outcomes aren't that precise. My general argument has been that the market is too focused on inflation, and that deflation is the primary threat. Many market pundits, on the other hand, have been proclaiming that the market (particularly the Treasury bond market) is massively underestimating inflation.

There are two primary market indicators for future inflation expectations: (1) the Treasury-TIPS spread and (2) the price of gold.

What bonds are telling us

As of 3/26/10, the Treasury curve looks as follows:

If you compare this curve to the curve at year end 2009, you'll see that the nominal Treasury rates have moved up slightly (the 30-year rose to 4.8% from 4.6%), TIPS rates moved up (the 30-year TIPS rate rose to 2.2% from 2.0%) and inflation expectations fell slightly (fell to 2.6% from 2.7%, yes there is rounding involved here). The TIPS curve is steep and the inflation curve less so, which makes sense. Below is what I consider to be the "equilibrium" yield curve, using my 2.25% inflation rate as a target:

The bond market is basically saying that the Fed will be a little slow to remove accommodation (which is why short rates are below equilibrium), but that long run inflation expectations are well-anchored.

What gold is telling us

The gold market is telling us something different. A rise in the gold price tends to lead a rise in commodities prices, which in turn leads a long term rise in CPI. Gold also has a history of volatility and of overshooting its equilibrium, however.

Below is a chart of the price of gold since the 1950s:

The gold price was fixed at its Bretton Woods price of $35 per ounce from the early 1930s to the late 1960s, jumped to (briefly) over $800 per ounce in 1980, fell to a new equilibrium range of around $375 per ounce from the mid-1980s through 1995, fell again in the late 1990s to $250 per ounce, and then rose during the past decade to over $1,000 per ounce.

If gold wasn't so volatile, we could expect it to rise steadily over time as the Fed promotes positive inflation. It should be noted that during the entire century between the early 1800s and the early 1900s, there was no sustained inflation in the United States as the dollar was convertible into gold at $20 per ounce. It is only since the Great Depression that the government has actively promoted inflation. In fact, because of the productivity of the capitalist system, you would expect prices to fall over time as producers became more efficient, not to rise as tends to be the case.

All things being equal, if you were expecting the Fed to target consumer price inflation of 2.25%, and you expect productivity gains of 1.75% per year, you would expect the gold price to rise by a rate of 4% per year to indicate that the dollar is being devalued accordingly.

Despite all the volatility in the gold price and inflation since the 1960s, the long term trend shows that gold has led increases in CPI, less a producitivity factor.

In the chart above, we can see from the trendline equation that CPI has been falling at a rate of 1.8% per year relative to gold since the 1950s, but that the relationship has been volatile. Gold was undervalued relative to consumer prices in 1970 and 2000, was overvalued in 1980, and was fairly valued in the mid-1990s. In many of my models I find that the mid-1990s was a well-balanced economy, before Robert Rubin's dollar bubble and the following dot com and housing bubbles threw the economy off kilter, to put it mildly.

One more factor to take into consideration is that economy-wide prices don't adjust instantaneously. I've found that it takes about 10 years for the overall CPI to catch up to a sustained devaluation of the dollar relative to gold. The inflation rate for the next 10 years is therefore dependent on whether monetary and fiscal policy are tightened enough so gold falls back in line with the current consumer prices, or whether prices keep rising to catch up with the new equilibrium level in gold.

My calculations of the theoretical gold price and CPI reveal the following:

  • If gold has overshot to the high side as a function of the financial crisis, and the treasury market's inflation rates are correct, then the current equilibrium gold price would be $550-600 per ounce.
  • If gold has found a new equilibrium level at the current $1,100 per ounce, then we should expect a 10-year inflation rate of over 5%.

This is a massive divergence.

  • If the bond market is correct, then bonds and non-precious metal commodities are fairly valued, and stocks are slightly overvalued.
  • If the gold market is correct, then most bonds are overvalued, TIPS and commodities are way undervalued and stocks and even real estate are slightly undervalued.

So what market should we listen to, gold or bonds?

The bond market is more liquid and understands the deflationary risks of high leverage. While the argument can be made that Treasuries are overpriced (yields too low) due to the Fed's holding rates too low and to Chinese manipulation. If nominal Treasuries were being manipulated by structural factors, then I would expect TIPS to be yielding nearly 0% across the curve. As can be seen above, however, the TIPS yield curve is showing positive real yields right around their equilibrium levels.

The gold market is a bit more ideological, attracting those that tend to dislike the government in power. It should be said, however, that the gold market was far more adept at tracking the debt bubble of the 2000s than the Federal Reserve proved to be, right through to predicting the extraordinary measures taken in the bubble's aftermath. The political landscape, on the other hand, is implying that consensus is building to fight the deficit, reform entitlements and to rein in financial system leverage. While that may be wishful thinking on my part, it would be hard to make the case that the wind is shifting in the other direction. My view is that the health care bill will be one of the last acts of giving us things for some time. The next decade will be occupied mostly by our government taking things away.


The answer to the debate is not obvious. Risk management, therefore, should be the primary focus for investors. I'll do my regular quarterly market update in a few days, but the lesson for me would be to overweight TIPS, commodities and cash, and to underweight precious metals. At the very least, it is probably time to trim bond positions back to a neutral weighting (I have been overweight bonds for years now). It also probably makes sense to have at least a neutral weighting in stocks for the time being, if we are to assume that the ultimate inflation outcome likely lies somewhere between what the bond market and gold market is predicting.

I am not a financial advisor. These analyses are conducted for personal enjoyment only.

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.


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.