Posted September 05, 2023
By Sean Ring
Dead Ben’s Amazing Ascent
- With all this fiscal expansion, why isn’t the dollar getting crushed?
- Because it trades against other currencies.
- And those currencies are in more trouble than the USD.
Good morning from a rather grigio (gray) morning in Northern Italy.
Last Friday, I had the pleasure of interviewing Jim Rickards for our new, yet unnamed video series.
Jim skillfully and thoroughly walked me through the entire banking crisis of early 2023, with Silvergate, Silicon Valley Bank, Credit Suisse, and First Republic. And with precise dates!
Jim was positively Sherlockian in dismantling the “crisis is over” thesis. I can’t wait until the piece gets through post-production and into your hands.
But before I let Jim sign off to drink his Aperol Spritz - Americans have finally discovered this fine aperitif - I asked him one question.
“Are you a dollar bull or bear?”
As a long-term macro thinker, Jim didn’t hesitate to say, “Bull.”
That may surprise you. After all, the dollar has been printed willy-nilly since 2008. The Fed’s balance sheet has exploded. Biden keeps sending dollars abroad to Ukraine.
When does it stop?
And that’s the irony.
Despite all this printing, the dollar is still the prettiest girl in this ugly currency parade.
In this edition of the Rude, I’ll go through why I think Jim will ultimately be proven correct, and perhaps sooner than anyone would have thought.
The Last Two Years
First, let’s look at the chart so we can get our bearing:
Throughout 2022, the USD index furiously rallied alongside Chairman Pow’s steep and sustained interest rate hikes (big green up arrow).
Well, until October. At that point, the market was convinced Powell would have to pivot and start cutting soon. This match lit the equities rally we’ve had for the past ten months.
From its high of 114.75 in October, the USD index fell to 102 in the first week of January 2023 (first big down red arrow).
Since then, we’ve had at least two sucker’s rallies (blue arrows). But the USD index has been predominantly rangebound between 101 and 105 for the year so far.
That big dip to 99.25 had many traders believe it was the end of the dollar. But that now seems to have been a false breakout to the downside.
Since that false breakout, we’ve rallied back up to 104.58.
If we get above 105.50, there’s a lot of room for a sustained run back up to at least 111, if not the previous high of 114.75.
The trouble with pricing a currency is that you compare money to… other money.
It’s much easier to visualize a stock price. There’s one share, and it has a price.
With foreign exchange, both “things” or “monies” represent a price.
So, what would make one piece of paper more valuable than another?
It’s informative to remember Benjamin Graham’s quote about stocks:
“In the short run, the market is a voting machine. But in the long run, it is a weighing machine.”
This applies doubly to currencies.
So, what do we mean by “voting machine?”
The Voting Machine
In the short run, when a country raises its interest rates, it offers lenders (such as banks, institutions, and investors) a higher return than other countries.
Consequently, higher interest rates attract foreign capital seeking the best investment return. This causes increased demand for that country's currency.
This increased demand tends to push up the price of the currency.
- Short-Run Supply and Demand: Most currencies are traded on a global foreign exchange market. Their values fluctuate based on supply and demand. If more investors or institutions want to own a particular currency, its value will increase.
- Interest Rates: Currencies from countries with higher interest rates often have higher values because they offer better returns on investments denominated in that currency. As you saw, the Fed rate hikes caused much dollar buying.
- Market Speculation: If traders believe that a currency will strengthen in the future, they will buy more now.
The Weighing Machine
In the long run, the strength of the economy, low inflation, and high real interest rates will drive the “smart money” to the best country’s currencies.
- Economic Indicators: Data like unemployment rates, manufacturing output, and consumer price indices influence a currency's value. Strong economic performance usually strengthens a currency.
- Political Stability: Currencies from countries with stable governments are generally more valuable because they're seen as less risky.
- Relative Interest Rates: It’s not just the absolute interest rate in a country that affects its currency's value but also how that rate compares with interest rates in other countries. If one country's interest rates rise while another country’s remain the same, the country with the rising rates will see an appreciation in its currency relative to the other. This is especially true in the case of highly traded currency pairs.
- Inflation and Real Interest Rates: Higher interest rates help control inflation. A lower inflation rate in a country compared to other countries can increase that country's currency's value. When comparing interest rates across countries, traders often look at the "real interest rate," which is the nominal interest rate minus inflation. A higher real interest rate will be desirable to foreign investors.
Digging Deeper Into the Index
First, let’s look at the dollar index basket constituents:
- Euro (EUR) - 57.6% of the basket
- Japanese yen (JPY) - 13.6%
- Pound sterling (GBP) - 11.9%
- Canadian dollar (CAD) - 9.1%
- Swedish krona (SEK) - 4.2%
- Swiss franc (CHF) - 3.6%
The euro isn’t dead yet, but it’s on life support. Germany is turning into Europe’s Rust Belt, thanks to the stupid “Russian” sanctions.
The Bank of Japan has attempted to murder the yen for the past thirty years.
Andrew Bailey, the Governor of the Bank of England, couldn’t find his bare ass with either hand.
Those currencies (EUR, JPY, and GBP) make up over 80% of this basket. How can you be bearish when you’re up against ECB Chief Christine Lagarde and this crew?
The only currency that has beaten the dollar consistently over the past two years is the Swiss franc, but that’s only 3.6% of the basket. Even so, the dollar has rallied against the franc lately.
Quick note: The first currency quoted is the base currency. For EURUSD and GBPUSD, the euro and the pound sterling are the base currency against the dollar. That’s why their charts are going down (since July). The dollar is the base against the other currencies we’re discussing here. That’s why it comes first in these pairs: USDJPY, USDCAD, USDSEK, and USDCHF.
Here’s a chart of all six versus the dollar:
The first chart is the EURUSD: since July, the EUR has fallen. The second chart is USDJPY. Since July, the dollar has rallied. The third chart is GBPUSD. The GBP has fallen since July. For the bottom three charts, the USD has rallied since July.
Looking at the constituent charts of the dollar index makes you wonder why anyone would be bearish on the dollar.
The dollar’s opponents just aren’t fit for purpose.
The EUR, JPY, and GBP are in trouble, primarily because their central banks are even worse than the Fed.
Look for the dollar to rally further, putting pressure on the stock, bond, and crypto markets.
And have a great week ahead!