Bullish on the U.S. Dollar
(November 4, 2011)
Dear Subscribers and Readers,
With the European Central Bank unexpectedly cutting its policy rate by 25 bps yesterday, and with the Bank of Japan pledging to intervene in the FOREX market to battle the rise in the Yen, it is definitely time to be open-minded about a rally in the U.S. Dollar Index. Perhaps just as important, there are really no alternative “reserve” currencies, especially with the Bank of England implementing its third round of quantitative easing—and with China slowing down, even the “commodity currencies” such as the AU$, the Brazilian Real, and the New Zealand Kiwi dollar have lost a significant amount of appeal (note that the Reserve Bank of Australia recently cut its policy rate by 25 bps to 4.5% several days ago—cutting rates for the first time since April 2009).
Note that global liquidity, as measured by the amount of US$ available in the world, is confirming our bullishness in the U.S. Dollar, at least for the first half of next year. This is important as most global trade is still transacted in U.S. dollars. In other words, despite the advent of the Euro and the Chinese Renminbi, the U.S. dollar remains the “lubricant” for world trade. Similar to a game of musical chairs, the “marginal” U.S. dollar borrower (e.g. Thailand in July 1997, Brazil in 1998, and Argentina in 2002) will be cut off if there is a declining supply (or a decreasing growth in supply) of U.S. dollars—resulting in a liquidity squeeze in major parts of the world. In such a scenario, the U.S. dollar and U.S. assets (e.g. Treasuries) would outperform. One indicator/measure of a potential US$ liquidity squeeze is the growth in the amount of foreign central bank reserves (which is pretty much all U.S. dollar-denominated) held in the custody of the Federal Reserve. Whenever the rate of growth of foreign assets held at the Federal Reserve banks decreased substantially, the U.S. Dollar has almost always rallied—typically resulting in some kind of foreign/global financial crisis. This is very logical, as an increasing growth of U.S. dollar-denominated assets mean an increasing growth of the supply of U.S. dollars - thus depressing its value. The following chart shows the level of foreign reserves vs. the annual change in foreign reserves (from January 1982 to October 2011):
Ever since the demise of the Breton Woods Agreement in 1973, the world has been on a de-facto U.S. dollar standard. Therefore, as world trade expanded, the demand for dollar has increased—and with it, the increase of foreign dollar reserves held at the Federal Reserve Banks. It is interesting to note that various financial crises or economic recessions (see above chart) have usually occurred when the annual change of dollar reserves is slowing down or experiencing negative growth. This growth rate has been as high as 36% in August 2004 but it has been decreasing since the beginning of 2010. The annual growth rate for October 2011 declined to just 3.1%--its lowest growth rate since March 2002! As US$ liquidity growth declines, other crises will inevitably pop up—and as such, the European sovereign debt crisis is likely to get worse, and with the ECB easing further, the Euro will inevitably decline against the US$, at least for the first half of 2012.
Finally, the U.S. Dollar Index has more or less been building a “base” since early 2008. Since early 2008, the US$ has engaged in two major rallies—once during the global liquidity squeeze from summer 2008 to early 2009; and another during the first half of 2010 (see following chart courtesy of Decisionpoint.com). It is now time for another major rally, which will be made even more powerful given central bank easing in the Euro Zone, the UK, Japan, Australia, and Brazil. We strong urge international clients to establish a long position in US$; and for our U.S. clients, a major shift back to local and U.S. dollar-denominated assets.
Henry To, CFA, CAIA