Dollar Starting to Pay Off

For months we have been wondering when the dollar will finally start to move higher versus the euro. The problems in Europe are massive and they will not go away. And yet the Euro seemed to be hanging around -- the damn thing has alligator blood. Well, the dollar is finally having its day. The market is pricing in a 95% chance of default on Greek debt, and Germany is prepared to shore up German banks in case of default. Euribor is spiking once again and the global system is experiencing tremendous amounts of stress. This feels eerily similar to 2008, only the epicenter is in Europe.

After a four month consolidation at levels close to the all-time-low in the dollar, the greenback has risen above the 76 range resistance and is trading above the 200 Day Moving Average (yellow line) for the first time since September 2010. Momentum is making a new high and the move is pushing the dollar above its one standard deviation trend as measured by the Bollinger Band. These are all great technical developments for our currency, but they are not great developments for the ‘risk assets,’ including stocks. Since 2008 the dollar has a 55% negative correlation to the stock market. That means when the dollar is up there is a very good chance that the stock market is down. Today, the S&P 500 is falling 2.5%.

For a brief moment there, I was in a good mood.

New Holding - U.S. Dollar Index Fund

Rick Vollaro wrote a brief article detailing the reasons why we recently purchased a new fund that tracks the value of the trade-weighted U.S. dollar index in most of our client portfolios.

Please click here to read Rick's article, which is posted over on the main Pinnacle website.

Dollar Breaking Down

This big news this week was that the European Central Bank (ECB) raised interest rates on Wednesday. While it was only a 0.25% increase, from a very low level (1% to 1.25%), it has had a big impact on currency markets. The euro has certainly gotten a big boost, and as a result, the dollar has been under renewed pressure, falling through an important technical level. The next critical threshold for the dollar is the low from late 2009, which is only another -1.5% from here. If that fails to hold, then the 2008 lows might come into play.

Why does this matter? Well, a falling dollar will only exacerbate recent inflation pressures. It will drive commodity prices even higher (since they’re priced in dollars), threatening the economic recovery. A lot of blame for the dollar’s weakness has been placed at the feet of the Fed. They currently aren’t even officially considering raising interest rates from their ultra-low level; instead, they’re still furiously pumping credit through their QE2 program.

Critics wonder about the necessity of such stimulus when the economy is supposedly almost two years into a new expansion. The Fed has countered that they’ll be able to successfully remove the excess stimulus when the time is right and prevent inflation from really taking hold. The action in the dollar seems to indicate that the market isn’t buying it.

Chart: Trade-weighted dollar index w/ underlying support levels

The Dollar as a Safe Haven

When equity markets are under selling pressure, as they have been this week, capital tries to find safe haven investments to flee to until the selling pressure eases. Over the last few years, and especially during the credit crisis of 2008, the safe haven for capital usually was the US dollar and US Treasury bonds. As the equity markets fall the price of Treasury bonds and the dollar rise because they are viewed as conservative or safe places to protect money. The chart below of the S&P 500 and the dollar demonstrates this relationship.

The S&P 500 is the white line in the chart using the right scale, and the US dollar is the orange line using the left scale. Dollar rallies (shown as green trend lines) and S&P 500 sell-offs (shown as violet trend lines) occur coincidently in time. Also, dollar sell-offs (shown as red trend lines) and S&P 500 rallies (shown as blue trend lines) exhibit this same relationship.

However, the last few days have created an interesting divergence in this relationship, as shown in the boxes at the far right of the chart. The S&P 500 has been falling but so has the US dollar. A few days do not make a trend (or in this case a relationship change) and we would expect the dollar to rally if the selling pressure continues. If this relationship does change, it will be very telling that the market no longer views the dollar as a safe haven play. I wonder if the Federal Reserve would see this as a sign to reassess the effect that Quantitative Easing has on our currency.

The Fight in Dollars

In September alone, the U.S. dollar was down 6% which is an annualized loss of 51%. This has led to big precious metals gains for the month as gold advanced 6% and silver soared 13%! The Federal Reserve has continued to monetize debt through permanent open market operations (POMOs) with dollar depreciation and asset inflation the result. But they are starting to get the attention of other nations in the fight over weaker currencies, and exports.

In the middle of September, the Bank of Japan had reached their limit when the Yen had risen to 82.80 versus the dollar and they decided to intervene in the currency markets. The yen dropped to 85 but has since reversed and is now trading at 83.30. Yesterday, Zero Hedge (another financial blog) reported that the Mexican government has intervened, and many other nations including Brazil, Peru and Colombia have also intervened to stem their currency appreciation. This, of course, comes on the heels of the fight between China and the U.S. over currency manipulation in which our own House of Representatives passed a bill that would raise tariffs on imports of a country artificially devaluing their currency. These are certainly dangerous waters to be surfing.

Brazil’s finance minister has blatantly stated that ‘we are in the midst of an international currency war’. And so far the United States has the upper hand as most international nations have clearly brought knives to a gun fight. That could very easily change though as these nations are major holders of Treasury debt. We sincerely hope that cooler heads prevail as trade wars were a big reason the recession of 1929 turned into the Great Depression. Since hope is not an investment strategy, we will gladly hold gold in our portfolio.

Correlation Breakdown

Over time, the price of gold typically has a fairly strong inverse correlation with the value of the U.S. dollar, meaning that they tend to move in opposite directions. But lately the dollar and gold have been moving higher in lockstep as the long-term inverse correlation has broken down (see chart below). There are a number of plausible reasons for the breakdown in the normal relationship between these two asset classes.

Start with gold. We are currently engulfed in the middle of a perfect storm of uncertainty: fears of eventual currency debasement in developed economies, worries about the long term viability of the Euro-zone, geopolitical tensions in Korea and Thailand, new signs of stress in the banking system, and even the recently attempted terrorist attack in New York City. That is one hearty list of unstable conditions, which has been supporting the gold trade recently.

As for the dollar, the trade-weighted dollar index, which is based on our largest trading partners, is made up of approximately 58% Euro. So, movements in that index are largely driven by movements in the Euro/dollar relationship. As the Euro has plummeted in recent weeks, this has been a huge driver of dollar gains. Other fundamentals such as purchasing power parity, real interest differentials, and future growth rates are no doubt operating beneath the surface. But quite simply, recently it seems like the Euro’s pain has been the dollars gain.

The traditional inverse correlation between dollar and gold appears to have recently decoupled. However, if the history of gold and the dollar remains a decent guide, then the longer-term relationship is likely to reassert itself at some point, implying that one of these asset classes is going to be wrong. The key will be in figuring out which one that is.

International Demand for U.S. Debt Remains Steady

Each month, the U.S. Treasury Department issues their Treasury International Capital report, which contains detailed information on international demand for U.S. securities. Normally, the report is not a headline grabber, and may only get a passing reference (if that) by most media outlets. But lately, some investors are paying more attention to this report, since the value of the U.S. dollar has come under increasing scrutiny. Since March 9th, which was the same day that equities bottomed, the dollar has fallen by -15% (on a trade-weighted basis), while the S&P 500 Index has rallied +62%. Since some countries (particularly China and Japan) have purchased very large quantities of U.S. Treasury debt, they aren’t exactly thrilled that their dollar holdings are falling in value, and have been very vocal lately about their desire to create some sort of new, global currency as an alternative to the greenback.

But for all the rhetoric, it seems that demand for U.S. debt has remained fairly steady. On a 12-month rolling average basis, foreign entities purchased $337 billion of U.S. Treasury notes and bonds in the year through August. As shown on the chart below, net purchases have held in a range of roughly $200 - $400 billion for the past several years, and foreigners haven’t been net sellers since earlier this decade. Part of the issue is that despite public statements, some countries have such large reserves that they don’t have realistic alternatives to Treasuries right now.

We’ll continue to monitor this data to see if these countries begin to back up their words with actions going forward, which could have very negative implications for the buck. But for now, it seems to be just a lot of posturing.

Range Bound Dollar

Over the past few weeks, the Dollar Index Spot Currency has been stuck in a range bound trading pattern between roughly $79.25 and $80.90 (see chart below). If this range bound trading continues for much longer there could be strong technical pressure on the dollar in whatever direction the breakout occurs. Technical traders will usually play the breakout for the length of the range which means the dollar could fall or rise $2 past the support and resistance lines. (I thought the usual mind set of short term traders might be of interest to you even though we at Pinnacle are more concerned of longer term trends). But which way will the dollar move? Some recent statistics have come out that might shed some light on the short term path of least resistance.

On Thursday, China released the latest data on their export activity. Year over year Chinese exports have fallen 21.4%, which was slightly worse than expected and the eighth straight month that the series has fallen. For an economy that relies on exports for roughly 1/3 of GDP growth this stagnation in export activity can’t continue without worry entering the markets. It is no wonder the government has thrown a large stimulus package at the system. If the stimulus does not ease the fall and worry were to enter the emerging markets then the currencies of those countries could have a setback and provide additional short term interest in the dollar. The dollar proved in 2008 that it remains the safe haven currency for the world (at least for now) regardless of anti-dollar rhetoric from certain countries.

Second, the US current account deficit as reported in May had the smallest reading since December 1999. No doubt there were many factors leading to this small number including the US consumer buying less and saving more and even exports outpacing imports. Nevertheless, a natural global re-balancing is occurring and that should ease some of the short term concern regarding the stability of the US dollar whether or not there is any correlation between them. And even though long term dollar bearishness remains I believe the dollar could have good support in the near term.

Strong Dollar is a Double-Edged Sword

One of the big worries within the financial community is that foreign investors, particularly China, might begin selling some of their large holdings of U.S. Treasury securities, potentially creating a nasty decline in the U.S. dollar. However, a look at the dollar’s chart (below) reveals that it’s been rising since last summer. There are many reasons attributed to the recent strength in the dollar: its role as the world’s reserve currency at a time of global deleveraging; investors who were “short” the dollar are now buying it back to close their positions; the U.S. economy may recover quicker than Europe thanks to much larger fiscal and monetary stimulus efforts, etc.

Forgetting for a minute why the dollar has shown such resilience, maybe I should just focus on the fact that a strong dollar has got to be great news for dollar-denominated securities, right? Well actually it hasn’t been great news for many of the multinational companies that have large offshore operations, because they’re more vulnerable to large swings in reported revenue and earnings if there are sharp movements in currency markets. A great example of this is Pfizer, which yesterday reported disappointing earnings and highlighted a $640 million loss of revenue due to adverse currency exchange movements. (Pfizer is 8.7% of the Health Care ETF owned in Pinnacle portfolios.)

When analyzing currency fluctuations in context of our portfolios we’re always torn by the double-edged sword that a rising or falling dollar creates on current and future portfolio performance. On one hand portfolio securities are affected by the real time total return gains or losses from a rising or falling dollar (including the Health Care ETF). But on the other hand future gains or losses may be offset or trumped by the dollar’s impact on earnings for the companies that are held inside of those securities.

The investment world has many quirks, oddities, and vagaries that will test the patience and intellect of even the most seasoned and even-keeled investors. So if it sounds confusing or perplexing that recent strength in the U.S. dollar can be both good and bad for dollar-denominated investments at the same time, I guess that should be considered par for the course!

Trade-weighted dollar with 50 (pink) and 200 day (blue) moving averages (Source: Bloomberg)