Exploring the "Dollar Crash" Thesis in Pictures

Mish

People have been predicting a crash in the US dollar for something like forever. Let's investigate another crash thesis.

ZeroHedge reports the "World's Most Bearish Hedge Fund" has a "Stunning" Theory What Happens Next to the Dollar.

Bear in mind the views that follow are not that of ZeroHedge but rather that of Horseman Global CIO Russell Clark who went 100% short in 2016 with negative results.

Clark did make money in 2017, an impressive result given the performance of the major indexes.

Clark's Theory

  • It is very easy to get bearish on bonds. With Chinese growth improving, and commodity prices rising, inflationary pressure is building. Furthermore, Chinese bonds currently offer 4%, substantially higher than developed market bonds. In addition, in a break with the Japanese experience of QE, the Federal Reserve has managed 5 interest rate increases, rather than only the one or two that Japan has been able to achieve since the bursting of the bubble. The refrain that I have heard these days is that QE works, and the US will be able to easily exit QE policies, followed by the ECB and the BOJ, and that bonds are a sell.
  • The big increase in QE from the ECB and the BOJ that we saw in 2016, has seen capital move from Japan and Europe to the US. This has meant that even as the US has raised rates, credit conditions have remained very favourable. This combined with a recovery in China has created an extremely favourable market for all assets in 2017. But what does it mean for 2018?
  • Well, if the QE model still holds, then the capital flows from Europe and Japan to the US are beginning to slow and even reverse. The implications of this is that the strategy is to be bearish US dollars and bearish on US corporate credit. It also implies being bearish on European and Japanese banks, and buying of bunds and JGBs, however this remains to be seen.
  • The worst-case scenario would be profound dollar weakness forcing the Federal Reserve to increase interest rates much more quickly than expected. Dollar weakness would cause Japanese and European exporters to suffer, forcing money into JGBs and bunds. This would be like the capital flight market in the US we saw in the late ‘70s. For reference, Swiss bonds yielded only 2% in the late 1970s, even as US rates went to near 20%.

In a nutshell, profound dollar weakness will cause the Fed to hike causing capital flight and huge rate hikes.

Let's explore the concept with pictures.

US Dollar Index vs. Fed Funds Rate

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Long-Term Synopsis

  • The US dollar index peaked in March of 1985 at 143.906. At that time, the Fed Funds Rate was 8.58%.
  • In August of 2011 the US dollar index was 69.061. The Fed Funds Rate was 0.10%.
  • The US dollar index dropped 52% while the Fed Funds Rate declined 8.48 percentage points.

Some might object that is too long a timeline to make a determination. We need something more "profound".

OK point taken.

Short-Term Synopsis

  • The US dollar index peaked in March of 1985 at 143.906. At that time, the Fed Funds Rate was 8.58%.
  • Three years later, in April of 1988, the US dollar index declined to 87.994. The Fed Funds Rate declined to 6.87%.
  • The US dollar index declined 38.85% in three years while the Fed Funds Rate declined 1.71 percentage points.

Cart Before the Horse

Perhaps that is still not "profound" enough.

Regardless, expecting the Fed to react to a falling dollar seems to put the cart before the horse. Let's shift the timelines to make that idea a bit more clear.

US Dollar Index Shifted 3 Years vs. Fed Funds Rate

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Explanation

To create the above chart I downloaded the Fred data from the first chart into Excel, then shifted the US dollar index back three years.

That is not a perfect correlation, but it's far better than the first chart. There will never be a perfect correlation but the following general guidelines apply.

General Guidelines

  • The Fed does not tend to react to a falling or rising dollar.
  • Instead, the dollar reacts to anticipated moves by the Fed and other central banks.
  • There may be leads or lags in any direction because it is not just the Fed in play.
  • In addition to anticipated moves by the Fed, what the ECB is perceived to do is of huge significance. Interest rates decisions by China and Japan matter considerably less.
  • Finally, there are flights of safety concerns, solvency concerns, and eurozone breakup concerns in play.

Sexy Predictions

Predicting a crash in nearly anything is sexy. People flock to such predictions, and bad predictions come and go, only to be embraced time and time again.

The US dollar index may crash. Yep, it might. But vs. what?

Please don't tell me the dollar will crash vs Bitcoin. Bitcoin is too small to matter.

Besides, that "crash" if you wish to label it as such, has already occurred. Bitcoin is now highly likely to crash vs the dollar.

Crash vs. What Major Currency?

  1. The European banking system and Target2 system are insolvent.
  2. The Chinese banking system is insolvent.
  3. Chinese State Owned Enterprises (SOEs) are insolvent.
  4. It takes massive amounts of debt for China to grow. China has one of the world's largest property bubbles.
  5. The US has a debt problem. But Japan's and China's are worse. The demographics in Europe, Japan, and China are also worse than in the US.
  6. The Yen and Japan's 20-year QE experiment are accidents waiting to happen.

Wile E. Coyote Moment

OK the US dollar "may" crash. But if you are predicting that, please tell us against what.

Lay out the case. Tell me where I am wrong regarding points 1-6 above.

Those predicting a US dollar crash float like the Wile E. Coyote in mid-air without a leg to stand on.

Gold in Play

The US dollar is not going to "crash" against the Euro, the Pound, the Yen, or the Yuan. Problems are similar if not far worse elsewhere.

Hyperinflation calls are absurd.

The US dollar could crash against gold and some believe will.

While I am not calling for a crash vs. gold, I would not be surprised in the least if gold went to $5,000 or higher.

One Recession From Crashing Rates

The irony in the dollar crash thesis is we are likely one recession away from crashing interest rates.

Meanwhile, please consider Mish Mailbag: Inflation-Deflation Debate - Bond Bears Still Wrong.

Also consider "You Bet Your Heinie" Bill Gross Needs a Fatter Crayon.

Just as happened in 2008 when oil soared over $140, people are coming out of the woodwork to proclaim massive inflation and dollar crashes.

But hey, predicting crashes is sexy.

Mike "Mish" Shedlock

Comments (33)
No. 1-33
KidHorn
KidHorn

One possibility is the countries who have a trade surplus with us don't intervene and let their currencies go up in value. Eventually, the values would reach an equilibrium point where trade is balanced. This is really how trade should work. Not likely. But not impossible.

Ambrose_Bierce
Ambrose_Bierce

The rate hike policy is in place to bolster the dollar, because if money isn't flowing into the US from ROW (looking for the best rates in town) then it can't go out through new T bonds sold to China. And if we can't roll that debt over several possibilities arise. We print money faster than it leaves the economy (negative money velocity) and to meet that they start freezing "stuff", no one is going to bury cash in a frozen bank account. Clark is right on, the question when did the Fed get this concerned about the dollar? It is by charter way down their priority list. If the Fed is immunizing the market against a weak dollar, then they could easily end the program, which could be the case, otherwise they might keep raising until something snaps and that seems irrational.

Mike Mish Shedlock
Mike Mish Shedlock

Editor

"I read that report also and found the assertion that a falling dollar would force the fed to raise rates rather bizarre. Why would it?" .... If anything it is the reverse. The Fed not hiking as much as expected leads to a falling dollar. That was my "cart before the horse" statement

Bam_Man
Bam_Man

All your points are well taken, Mish.

Bam_Man
Bam_Man

The Dollar is currently crashing against equities and somewhat, but less so versus oil and Gold. Given the astronomically obscene amounts of debt everywhere (households, corporations, governments at every level) Interest rates cannot continue to rise for much longer, or it will cause a major debt-deflation induced depression.

Bam_Man
Bam_Man

At which point corporate bankruptcies will occur and scare the beejeesus out of those invested in equities - forcing them into the relative safety of - you guessed it - government bonds.

8dots
8dots

$TNX, log. The resistance line from Nov 1994, make enough room for the 10Y to rise in direction of 3.5%, without any justification for bonds bears fears. The story of the Fed raising rates on Jan 25th, two more times in 2018 and two more times in 2019, is a typical story of inflation expectations.

8dots
8dots

In the meanwhile the ECB was hit by Brexit, which reduce European GDP and population. Europe try to fill the gap by adding Bosnia, Albania and Gaza. So fat, there is no shutdown of the German govt, there is no govt in Germany, which is becoming unstable like Italy.Europe, without the UK, with unstable core makes ==> $USD strong. The toxic diplomatic relationship between China & Japan and S + N. Korea marching under one flag, potentially seducing S.Korea to become a Chinese concubine, is another bad sign for Japan.

8dots
8dots

If China renege on their debt to Japan, because Japan historical crimes, the $USDJPY will go to = 300 ==> another reason for $USD strong.

8dots
8dots

A US govt shutdown will enable the existing leader in the white house to declare an emergency rule in the USA, to consolidate power and start a process of toxicity cleansing in the body. No more daily intake of blood pressure medication, or opioid to suppress pain. Cleansing historical entitlements, consolidate position of the US empire, in order to reduce debt. The theft of the Xmas tax cut gift from the American people - blamed the other side. Again, ==> another reason for $USD strong, unless the US health is already too fragile, and cleansing will create a lot of future troubles.

8dots
8dots

1)The $USD have a support line from the 2011(L) and the 2014(L). So far, the $USD > 90(c). Still, plenty of room to fall until a touch down of the resistance line. 2) In between a trading range between 82 to 88, which is another support. 3) The spikes, the sharp fangs of the 2008, 2009 and 2010 peaks, will rip apart any dollar bears.

Carl_R
Carl_R

So you've shown that zerohedge is wrong (again). How is that news?
Since you mentioned Bitcoin again, I'll mention that today a guy that I knew years ago as a guy that did odd jobs, and who now drives a cab, and struggles to get by, called me today and asked "what are bitcoins, and should I be buying them?" If guys like him are thinking about buying them, I certainly wouldn't.

Greggg
Greggg

Something will have to happen with the debt. We could slowly pay it off, write it off, or linger in perpetual debt servitude. I don't think the public likes any of the three choices.

Greggg
Greggg
Greggg
Greggg

No mention of the petro dollar, but this came out today, so it's fresh. Basic.

TheLege
TheLege

It's in the interests of all major economic blocs to devalue their currencies roughly simultaneously - so that few realise what stunt is being pulled, right in front of their eyes. Only Gold can sound the alarm bells -- once this happens Central Banks (and world Govts) will have a real challenge on their hands.

killben
killben

"in a break with the Japanese experience of QE, the Federal Reserve has managed 5 interest rate increases, rather than only the one or two that Japan has been able to achieve since the bursting of the bubble."

It is conveniently forgotten that during the Japanese experience of QE, it was the only country doing it and thus it had no cover. Whereas the Fed had the ECB, BoJ and PBoC to cover it. Let us see them ALL also unwind and increase rates. If they are able to do it, I would believe that the central banksters are the magicians they proclaim themselves to be. By the same token, if it comes unstuck (which I think will be the case) lamp post and rope should be in order.

dogbone
dogbone

Mish - this article in BRILLIANT. It does an incredible job of explaining to the brainwashed "dollar crash" crowd why their theory is so wrong. The only ting the US dollar COULD crash against is GOLD, but that is probably a long way off.

dogbone
dogbone

I also think the mainstream media propaganda we've are treated to now that "bonds can only go down" is happening because the Feds are desperately trying to twist the treasury yield curve into a shape more to their liking - i.e. steeper so the banks make more money. No, in truth, the primary trend is DOWN for bonds signaling no economic opportunity in the real economy. Why would anyone with money want to invest in the real economy were they actually must TAKE RISK when the Feds are giving away FREE credit (money) in the financial markets?

Ambrose_Bierce
Ambrose_Bierce

problem there is that FED is still hiking faster than anyone else and makes US markets a hot money destination. Record trade surplus with China, before FED calls BIS with those new cusip numbers they better think about where the money is going to come from, and it sure aint going to be new tax revenue. FED is out of its game plan here, and that is worrisome. The longer maturities are not moving as much, hence the yield curve is really inverting, otherwise paying the interest on those cusips would be another nail in the deficit coffin. No way out now. The Trump tax plan is the death cross, and should Dems win back Congress they would do well to keep it, give the Donald everything he wants, its all future manna.

Advancingtime
Advancingtime

Mish has done a super job of explaining why the dollar will remain strong. One of the most important things to remember about the global currency system is that by design it is fairly closed. This means relative value tends to merely shift back and forth between the four major currencies that dominate the system, this is the main reason currencies appear more stable than they really are.

It only becomes a real problem for governments to deceive us as to the real value of our currency when this bond is broken. Unstable currency markets can be a precursor to massive shifts in value and a sudden drop in confidence. It is logical to think that in such a situation insiders would be the big winners. More on this subject in the article below.
http://brucewilds.blogspot.com/2016/08/currency-games-scream-major-risk.html

MntGoat
MntGoat

We could have an asteroid storm destroy the earth and the stock market would still be up the next day

El_Tedo
El_Tedo

An asteroid hit would be a great stimulant to the economy; consider all the broken windows that would need repair.

Ambrose_Bierce
Ambrose_Bierce

bad news a rogue asteroid is headed toward Earth! good news it's made of gold, we're all going to be rich

truthseeker
truthseeker

Mish the last 3 weeks the COT report has been very bearish for gold imo. You told me that when gold made its record run back in 2011 the commercials were short all the way up. I can agree with u that the precious metal miners back then having never seen prices that high except for the Hunt brothers spike years ago, were hedging more each week until silver got to around $50 and gold near $1900. At these levels both were way overpriced so that gold dropped all the way back to around $1040 while silver fell to somewhere in the low teens I’m guessing. Since that time from what I’ve read the so called “bullion banks”have taken over the trade in the futures market way beyond the volume the miners have used for hedging over the years.. I guess the point I’m trying to make is that the banks have the backing of the Fed and probably even the treasury to do whatever it takes to keep the price of gold from getting out of hand. There are a good number of people in the PM area who understand how the banks manipulate the paper price a whole lot better than I have tried to do here, as my comments r so poorly expressed I should probably delete all this.

truthseeker
truthseeker

Mish I guess the x means what I have said here is not true, yet I didn’t make this up. I’m really sorry for not having said exactly the way you told it to me. Since I know you still have the comment you made to me, if you don’t mind would you please tell me what you did say to me?

100 Hillbillies
100 Hillbillies

Maybe I missed it, but what about countries dumping treasuries?

100 Hillbillies
100 Hillbillies

Or Yuan-denominated oil?, i.e. no more petro dollar?

100 Hillbillies
100 Hillbillies

or this: Jan 17 Dollar Reaches Multi-Year Lows as Central Banks Shift Reserves Into Yuan by Marc Chandler (?)

100 Hillbillies
100 Hillbillies

We may be called Hillbilly, but they put fiber optic down the coulee last year.

100 Hillbillies
100 Hillbillies

One last link: Non-Dollar Trading Is Killing the Petrodollar -- And ... - Huffington Post

dogbone
dogbone

I made a mistake in my last post. I said bonds will go down. I need to be very specific about the language. I meant bond prices will continue to go UP, while bond yields will go down.

dogbone
dogbone

To me, the basic confusion here lies with the "Quantity Theory of Money". This theory holds that it is a truism that as the quantity of a given currency rises, the value of the currency must drop. This theory is not always true because excess currency and credit does not have to go into the real economy and bid prices up there. It can also go into the financial markets and bid prices up there. We are seeing this now. The central banks are hoping their money creation will go into the real economy and create some inflation there. That is not happening. Every deflation has a soaring bond market, yields will get closer and closer to zero, but nothing goes in a straight line. What really defines the strength of a currency is the quality of the currency, that is defined primarily by the quality of it's bond markets. Also, it is the struggles of the debtors to repay debt denominated in a currency that is often what keeps the currency strong. Just look a Japan.


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