Friday, November 20, 2009
Dollar doomed? Not so fast
If you ask the average Professional Trader/Investor their opinion on the Inflation/Deflation debate, chances are they will tell you we are headed into a period of hyperinflation, Gold is headed to $5,000 an ounce, and the U.S. dollar is done for. This is evident by the EXTREMELY bearish sentiment numbers on the U.S. Dollar, and the EXTREMELY bullish sentiment numbers on Gold. Very few traders think the dollar is putting in a major bottom and commodities and equities are putting in a major top. This extremes in sentiment to one side of the trade is precisely why I take a contrarian view. I do think the dollar is currently in the process of making a significant bottom. This is supported by both the technical and fundamental aspects of the U.S. Dollar. Fundamentally, what we saw last Fall (2008) was consumers and businesses deleveraging, going into conservator ship mode. The credit markets were almost completely frozen, and debtors were racing to find dollars to pay back their creditors. In order to accumulate dollars, people had to sell their assets, and buy dollars. This simple supply and demand relationship sent asset prices plummeting and the value of the U.S. Dollar soaring. It does not seem to me that this process of debt retirement is finished. Essentially, for so many years, consumers have been short U.S. dollars (borrowing in U.S. Dollars). When the dollar is weak, and asset prices are on the rise in terms of dollars, the music in musical chairs is still playing, and the consumer can continue to borrow at low interest rates and withstand a substantial sum of debt on their personal books. However, when asset bubbles (in the most recent case the housing bubble) pop and the music stops, prices and asset values plummet, and people start to pile out of the "Short Dollar" trade, essentially "covering their shorts" by selling their assets in order to pay their debt. The fear that ensues in markets after asset bubbles pop act like a domino effect. Prices fall, which induces more selling, which in turn causes prices to fall further. This process is completely necessary to rid the system of excesses. However, in doing so, there is a substancial CONTRACTION in the money and credit supply, thus leading to DEFLATION, not inflation. Inflationists will argue that the fed can always just print more money and keep the money supply up through that method. It is true that the fed can print as much money as they want, but I think a fundamental issue that people miss about the Inflation/Deflation debate is the fact that you can lead a horse to water but you can't make him drink. Bank credit has contracted since the March bottom in asset prices, and this implies that banks are unwilling to lend. The money is not getting out into the economy, and even the supply of money that is added, is dwarfed by the volume of credit destruction, or in other words contraction. I also think people commonly mistaken the definition of inflation. They think it refers to the supply of money in the economy. In fact, M3 is determined by the supply of money and CREDIT, and what we have seen these past few decades is credit inflation, not monetary inflation. With Banks leveraged up 30:1, 29 dollars of credit was created for every dollar deposited by a saver in a Bank. While other banks were not as leveraged, there still was credit being created out of thin air. What started in 2008 is what I believe to be a multi-year process of debt retirement, deleveraging, credit contraction, and thus DEFLATION, not inflation, as many people argue. After the system is cleaned out of all its excesses, can there be inflation and thus reason to worry about the dollar? Absolutely, but all the talk of the dollar losing its reserve status and losing all its value is most likely off by a few years. Consider the Stock Market bottom in early March. Nobody wanted to buy stocks when the Dow was trading at 6,500. Everybody was talking about the Dow going to 5,000, more layoffs, bankruptcies, and the complete collapse of our economy was not out of the question in the minds of most. Of course, none of that happened, and the stock market has rallied 50%+ since. Now all of a sudden stocks are attractive again, and complacency has returned to Wall Street, specifically in commodities. It is this extreme level of bullish sentiment, that convinces me commodities are due for a reversal in the near future, possibly after a blow off top in Gold, just like we saw in Oil in the Summer of 2008, when it hit $147, only to crash to $35 by the end of the year. The "gloom and doom" pessimism that existed in the stock market in March now exists in the dollar. Consider this daily Chart of the U.S. Dollar Index a measure of the value of the U.S. dollar against a basket of currencies. From a technical perspective, momentum on the downside has clearly been waning, and the Dollar looks just as attractive at these levels as stocks did in march; To a contrarian, that is.