Strong U.S. Dollar Will Cut Off Inflation Before It Starts

NEW YORK (TheStreet) -- As the U.S. dollar continues trending higher, inflation may have difficulty picking up steam.

PowerShares DB US Dollar Index Bullish (UUP)  is up nearly 6% since early July as the U.S. economy has been relatively much stronger than its European counterpart. The dollar index is comprised of 57.6% trade with the euro.

Eurozone economic growth and factory activity have broadly declined in 2014, leading many European officials to call for policy loosening to aid the recovery. In contrast, the U.S. economy picked up momentum this year, causing market observers to speculate that the Federal Reserve could soon raise short term rates.

The dollar saw a significant spike higher against the euro last Thursday as the European Central Bank cut its main refinancing rate to 0.05% from 0.15%, with ECB President Mario Draghi stating that more stimulus in the form of quantitative easing could be on the table in the future.

UUP Chart
UUP data by YCharts

U.S. dollar strength tends to have an adverse effect on inflation as a stronger dollar gives consumers more purchasing power, while making imports such as gold and oil relatively less expensive.

The chart below highlights the relationship between the U.S. dollar and the U.S. Consumer Price Index to 1990. The two share a strong inverse relationship, with large declines in the dollar generally leading to an advance in the inflation measure.

Inflation tended to fall at the onset of each recession but quickly picked up in the aftermath as the U.S. dollar continued its aggressive decline.

Since 2011, however, the dollar has developed a strong bottoming formation, and looks poised to trend higher. Consumer inflation has moved lower over that span, and could have difficulty pushing above the Fed's 2% annual inflation target if the dollar continues its advance.

 

Data provided by the Federal Reserve

Two sectors that will be affected by falling or stagnant inflation in the U.S. are iShares Dow Jones Transportation Average (IYT) and Market Vectors Gold Miners ETF (GDX) .

The transportation ETF is comprised mostly of FedEx  (FDX) , Kirby (KEX) , Kansas City Southern (KSU) , United Parcel Service (UPS)  and Union Pacific (UNP) .

While the gold miners ETF is made up of Goldcorp  (GG) , Barrick Gold  (ABX) , Newmont Mining  (NEM) , Silver Wheaton (SLW)  and Franco-Nevada  (FNV) .

Transportation stocks are sensitive to oil prices as fuel represents a large cost to operations. When oil prices decline, with all else being equal, the companies tend to increase profits, which benefits share price.

The chart below signals that the relationship between a stronger dollar, falling oil prices and share price gains in transportation stocks has held up well over the past six months.

UUP Chart
IYT data by YCharts

Meanwhile, gold mining stocks tend to fall alongside the price of gold. When the metal declines it cuts into profit margins and makes investment in future projects less attractive to miners.

Gold is considered by many a hedge to the U.S. dollar, trading inversely to the currency. As the dollar advances, leading to stagnant inflation, demand for gold should similarly decline.

The relationship has also held up well over the past six months as the dollar has increased, driving the price of both gold and gold miners lower, as is seen below.

With the divergence of monetary policy across the globe, the U.S. economy looks to be better off than many in the developed world, including its European counterpart. This should continue to push funds into the dollar, cutting off large advances in inflation measures, and also benefitting companies sensitive to low inflation.

UUP Chart
GLD data by YCharts

 

At the time of publication, the author held no positions in any of the stocks mentioned.

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This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.


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