The dollar is in danger , but is this the endgame?
It's broken down through a key level of support.
What could save it?
What are the implications of further falls?
Let's take a look…
A Century of Devaluing the Dollar
The chart below shows the US dollar index – that is, the US dollar measured against a basket of foreign currencies. This is divided roughly as follows:
Euro (EUR): 57%
Pound sterling (GBP): 12%
Canadian dollar (CAD): 9%
Swedish krona (SEK): 4%
Swiss franc (CHF): 3.5%
Japanese Yen (JPY): 13.5%
We start with a 15-year chart, so we can see the performance of the dollar in some kind of long-term perspective. As you can see, the last ten years have been a decade the US dollar would rather forget.
In fact the last near-100 years – since the formation of the Federal Reserve Bank in 1913 – are an era the US dollar would rather forget. In that time it has lost something like 98% of its purchasing power. Given that the Fed was created to 'protect' the dollar, I am surprised it still has the job. If I put in an equivalent performance for MoneyWeek, and lost 98% of their readers, I'd have long since been sacked.
But some credit has to go to the Fed for its performance of late. Ben Bernanke's insanely inflationary, loose-monetary policies of artificially-low interest rates and quantitative easing (QE) have had the specific aim of devaluing the dollar. The goal is to devalue US debt, while creating a reassuring boom in asset prices. In that regard it has succeeded. Those who hold the notes have, via the clandestine erosion of inflation, paid the bill.
Is the Dollar Breaking Down?
I watch this next chart of the US dollar most days. I see it as incredibly important in the grand scheme of the things. The dollar is the global senior currency. And there is a danger it is breaking down.
You can see I have drawn a blue trend line off the lows of spring and summer 2008. These occurred when commodities and, oil in particular, were reaching record levels.
In recent days, the dollar has broken down through it.
At the end of the day, to use a footballing cliché, this is just a blue line on a chart. But it also signifies a channel, or a trend – one that now is broken. The dollar benefited from the forced liquidations of 2008 and 2009. But the pressure of the 'global margin call', as my friend the private investor Dr John Wolstencroft put it, is now gone.
I would say that, next, we test 74 on the chart. If that doesn't hold, we make our way down to the all-time lows around 71. If they don't hold, this could quickly turn into an inflationary rout. The Fed may then need to resort to dramatically higher rates to stop a full-scale run on the dollar.
But What Could Make the Dollar Rally from Here?
Quite a few things, actually.
In recent years, the dollar has traded in the opposite direction to asset markets. The stock market rises, the dollar falls, and vice versa. But the Arab and then the Japanese panics sent both stocks and the dollar lower. So falling asset prices may no longer save the dollar the way that they did in 2008.
But the dollar has now hit extreme levels against a number of currencies. And extremes often mark turning points.
The yen was already at multi-year highs against the dollar before the Japanese crisis began. Then the 'repatriation trade' has sent it even higher. But when the Japanese start spending in earnest to rebuild their country, this could well mark the turning point.
As for the Canadian dollar, it has soared with commodities, but it is now trading at parity. Historically, this has been a level at which to be long the US version.
Regarding the euro, which makes up over 50% of the index, how long before the next leg of the crisis in the PIGS countries? In fact, it may already have begun in Portugal, whose debt was downgraded last week, and which could face a change of government as early as today.
And what of the pound? Even that miserable old dog has been buoyant against the dollar in a gentle rally that began shortly after Gordon Brown left Number 10. At $1.63 it's in the middle of the range. It may well pull back a little, but there is nothing like the same downward pressure there was when Brown was in charge. But there are plenty of reasons to be bearish, not least the fact that interest rates are still at 0.5% even although inflation has 'unexpectedly' moved over 4%.
The Key Issue for the Dollar – the Launch of QE3
But perhaps the real determinant of the direction of the dollar will be whether we get more QE – QE3. The current bout, QE2, stops in June. Last summer, the slightest wobble in the stock market had Bernanke quickly ushering in round two. As a result, markets now seem to be expecting another round, no matter what happens. After all, the Fed has set a precedent. And Bernanke has shown himself to be very much a 'can print, will print' kind of guy.
But this week the US Supreme Court, surprisingly perhaps, ordered the Fed to disclose details of emergency loans it made to banks in 2008, rejecting an appeal that aimed to shield the records from public view. This is the first time a court has forced the Fed to reveal the names of banks that borrowed from its oldest lending programme, the 98-year-old discount window.
I doubt there's anything significant in these details that we don't already know. But you never know. This order could well mark a sea-change in transparency. Who knows? It may smooth the passage for Congressman Ron Paul's 'Audit the Fed' bill to be passed.
It could all lead to public pressure for a tightening of monetary policy. And if the price of oil and other key commodities continues to rise, the Fed may not be able to get another bout of QE away. Which would be extremely bearish for stock markets, but bullish for the dollar.
For my own part, the more I look at this great big mess that is central bank monetary policy, the more glad I am that I own gold. For now I see the dollar trickling even lower. And if it breaks the 70 mark – well, the US will be a cheap place to go for the summer holidays, even for us Brits.
This article first appeared in Money Morning, the free daily investment email from UK investment magazine, Moneyweek. Sign up here - it's free.
