After sliding to its lowest
levels in history this week, the flagging US dollar has captured the
limelight. And it certainly
should. The dollar is like
nothing else, a critical linchpin that links every market and asset of global
importance. The implications of
the dollar’s fall from grace are profound and universal.
It’s funny, as a
surprising number of mainstream analysts on CNBC in recent weeks are talking
as if this dollar weakness is new.
Apparently they have no historical charts. The dollar, as measured by the
flagship US Dollar Index (USDX), has been in a secular bear market since July 2001. It has lost 39.2% of its value since
then.
And believe it or not,
contrarians were well aware of the dollar’s peril even at its very
top. Just two weeks after its
apex, I penned an essay called “Real Rates and Gold”. It discussed a coming
“spectacular gold rally” and a “horribly debased US
dollar”. On a lazy July
Friday in 2001 when gold closed at $270 and the USDX at 117, I wrote…
“So what is a central
banker to do? Stop lowering
interest rates and risk a huge implosion of the fragile US
equity markets or keep lowering interest rates and push real rates negative
risking a huge gold rally and eviscerating the dollar?” Provocatively, this old paragraph
nicely reflects the Fed’s dilemma in 2008 too.
Although few remember
today, the key catalyst that got early contrarians excited enough to buy gold
in the $260s when everyone else scoffed at it was negative real rates. Thanks
to Alan Greenspan’s aggressive rate cuts designed to
bail out NASDAQ speculators, by the summer of 2001 real rates looked to
plunge decisively negative for the first time since the 1970s. It was incredibly bullish for gold.
Real interest rates are
simply the nominal headline yields that bond investors earn in
“risk-free” US Treasuries less the rate of inflation. Normally real rates are positive, investors earn a nominal return higher than
inflation. But sometimes the Fed
drives real rates negative, forcing real losses in purchasing power upon bond
investors. Inflation erodes their
investments faster than nominal yields grow them.
Over the years since 2001,
gold and gold-stock investors and speculators (including our subscribers) have earned
fortunes trading on this negative real-rate thesis. I ended up writing 9 essays on this
thread of research, the most recent of which was September 2007. Whenever the Fed willingly chooses to
render bond investing unprofitable, investors move capital into gold to
thrive despite the Fed’s attack on them.
Sadly today, just like in
the 1970s, the Fed is once again trying to rob investors. We have a Fed chairman hellbent on dropping nominal interest rates to zero, all
in the name of bailing out irresponsible real-estate speculators that fully
deserve all the losses coming to them.
Meanwhile the Fed is ramping up the money supply at truly frightening
rates, unleashing tremendous inflation.
We’re in a perfect monetary storm.
Since Ben Bernanke started slashing rates in a panic in September
2007, real interest rates have fallen faster and farther than anything
witnessed since the 1970s! Even
as a long-time student of real rates, I find this plunge stunning. Thanks to this slashing campaign,
global investors can no longer earn positive returns after inflation in
shorter-term US Treasuries. So
naturally they are exiting the US dollar to search for greener pastures
elsewhere.
In such a hostile
environment for investors, the new all-time USDX lows aren’t surprising. Last May I warned they were coming. But as I’ve pondered them
recently, I realized I’ve neglected a key research thread. I’d never directly compared the
USDX with real rates, only gold. So
this week I thought it would be interesting to examine the dollar’s
fortunes through the lens of real interest-rate trends.
To calculate real rates,
I’m following the same conventions from my real rates and gold studies. The nominal interest rate used is the
yield on 1-year US Treasury Bills.
While not widely traded today, the Fed maintains this data
series. It is rendered below in
black. For inflation, I am using
the year-over-year change in the Consumer Price Index (white). Nominal rates minus inflation equals
real rates (blue).
Now I fully realize the CPI
is a joke as Washington has
huge incentives to radically understate inflation in its headline index. Nevertheless, the CPI is widely accepted
today by mainstreamers as the
definitive inflation gauge. So
I’m using this lowballed index here which
really understates my case. If real monetary inflation was used
instead, as it ought to be, real rates would look far worse than they do in
these charts.
While the heavily
manipulated CPI is showing 4.3% absolute annual inflation per its latest
read, monetary inflation is far
worse. Bernanke’s
Fed has ramped the MZM money supply by an
eye-popping 15.4% over the past year!
And this is its absolute year-over-year change, it is not
annualized. Thus true inflation
in the US
is probably pushing double digits today despite what the CPI is trying to
convince us.
I did change one key thing
with this USDX comparison versus my earlier gold work. Instead of using monthly data for this
multi-decade chart, I upped the resolution to daily data to try and better
reveal real-rate extremes. The
CPI is still only available monthly of course, but it can be compared to
daily T-Bill yields. Thus there
are nearly 30k data points in this first chart. The
USDX is superimposed on
top in red.
Real interest rates are a
powerful trading indicator, but it is important to realize their signals
operate at a secular scale. The
USDX, or gold for that matter, will not usually instantly respond to
real-rate changes. This is not a
tactical day-trading indicator.
Nevertheless, it doesn’t take too long for investors to catch on
to real-rate trend changes and start moving their capital into and out of the
dollar and gold accordingly.
I think the easiest way to
digest this chart is to follow the dollar’s journey since 1971 through
the lens of real-rate trends. In
the 1970s real rates were low or negative most of the time, and the USDX
ground lower on balance throughout the entire decade. Interestingly the USDX tended to be
the most stable when real rates had been climbing and were positive, such as
in 1976.
The 1970s are also
interesting as they prove that Treasuries investors pay careful attention to
inflation too, not just nominal yields.
In 1978, for example, T-Bill yields averaged 8.3%. This sounds very impressive in
isolation, investors today would kill for such a yield. Nevertheless, inflation ran so high
that real rates only averaged 0.7% that year. And the USDX suffered for it, down
10.3% in calendar 1978. Investors
do watch CPI inflation!
Real rates bottomed at
-6.75% in June 1980. Interestingly
this was due to YoY CPI inflation growth still
running at 14.4%, not immediate Fed action. 1y T-Bill yields had hit an interim
peak a few months earlier at 16.5% in March 1980 but were down to 7.6% by
June. Paul Volcker’s
inflation fighting, started soon after his August
1979 appointment as Fed Chairman, didn’t take long to start bearing
fruit. Americans had to pay a
heavy price for the inflationist Fed of the 1970s, a hard lesson Ben Bernanke has apparently forgotten.
Provocatively the USDX
bottomed in July 1980 just one month
after real rates bottomed. Global
investors started buying the dollar again even when real rates were still
negative because Volcker’s inflation-fighting
campaign was credible. By May
1981 real rates had rocketed back up to +7.1% and investors were scrambling
to buy dollars and Treasuries. 1y
T-Bill yields ran 16.9% but inflation had fallen to 9.8%.
While nominal rates soon
came down, for almost all of Volcker’s reign
until August 1987 he kept nominal interest rates well above inflation.
You can see this above with the blue line oscillating between 4% and
8% in much of the 1980s. With the
real yields so high in sovereign US debt, international capital
flocked to the dollar. The USDX
went parabolic and topped at a staggering 164.7 in February
1985. It had soared 95.8% since
July 1980!
While this parabolic ascent
had to be followed by a crash in purely technical terms, the dollar
didn’t have to fall as far as it did. If real rates had stayed so high and favorable, it probably would have bounced between 130 to 140 on the USDX. But real rates plunged from 8.1% in
June 1984 to 2.1% in October 1987 just after the infamous stock-market
crash. Over this span, the USDX
fell 30.9% to 94.
Thus it seems crystal clear
that falling real rates really mattered to investors. Their demand for the dollar and US
Treasuries waned with falling inflation-adjusted returns. This trend actually continued to
October 1992 when real rates briefly fell negative. Provocatively just one month earlier
in September 1992, the USDX hit an all-time low of 78.33 as real rates
threatened to go negative. The
USDX lost 52.4% in that secular bear driven
by falling real rates.
After Alan Greenspan
finally raised rates six times in 1994, real rates stabilized for the rest of
the 1990s around 3% or so. While
this wasn’t a great yield, it did still help attract in international
capital. So the USDX began a long
50.6% secular bull from April 1995 to July 2001. What ended this particular dollar
bull? Thanks to Greenspan’s
aggressive rate cutting in 2001 to bail out stock speculators, real rates
were heading to zero.
Today a lot of mainstream
analysts attribute the USDX’s mighty bull of
the late 1990s to the strong US
stock markets. While attractive
stock markets don’t hurt, real rates were likely a far more important
factor in the dollar’s strength.
The USDX’s bull started soon after
real rates went above 3% in 1995 and it ended when they fell to 0% in
2001. Interestingly by the time
the USDX peaked, the SPX and NASDAQ were
already down 20% and 59% from their early 2000 highs. Real rates, not stocks, drove the USDX.
Since its July 2001 peak,
the USDX has fallen on balance in a relentless 39.2% secular bear. Real rates remained low or negative
for most of this period. There
was one spike in 2006 which I will discuss below, but it didn’t
last. As long as international
investors have little hope that the Fed is willing to set interest rates at
reasonable levels above inflation rates,
they have no reason to buy US dollars.
The moral of this long-term
dollar story? Real rates are
probably the single biggest factor affecting the dollar’s secular
fortunes. The USDX has never
enjoyed a secular bull without healthy positive real rates. And it has never experienced a secular
bear without falling or negative real rates. So if you want to game the US
dollar’s secular trend, see how its sovereign debt is yielding relative
to domestic inflation.
My next chart zooms in to examine
today’s secular dollar bear since 2001, the portion of modern history
most relevant to us now. Even at
this much shorter scale, the influence of real rates on the dollar’s
fortunes is readily apparent. Inflation-adjusted
yields are truly a huge factor in international investors’ decisions on
whether or not to deploy capital in dollar-denominated debt investments.
While the USDX technically
topped in July 2001, it made a slightly lower secondary top in January
2002. Note that its behavior between these tops approximates real rates
pretty well. The USDX really
started plunging when real rates again fell under 1%. I doubt bond investors believed the
CPI though, that inflation was only running 1.1%, in early 2002. So they probably already perceived
real rates as negative.
Provocatively the USDX
didn’t carve the first sustainable low of its bear until December 2004
when real rates were finally heading positive again. The USDX kept rallying with rising 1y
T-Bill yields into late 2005 when CPI inflation again outpaced nominal
yields. With real rates still
under 1%, the dollar started lower again but it remained well above its late
2004 lows. The USDX was indeed
stabilizing as real rates rose.
Then in September 2006,
real rates skyrocketed to 3%. You’d
expect these healthy real rates would lead to serious dollar buying, but they
didn’t this time around. This
whole gain in real rates was due to a big drop in the CPI in September and
October 2006. But this coincided
with a CPI calculation methodology change and I don’t think
international investors believed it.
1.3% inflation in late 2006?
No way.
After this suspicious CPI
ebb, underlying monetary inflation forced even the
“new-and-improved” CPI to rise. Real rates fell from 3% to 2% and
dollar selling resumed.
Interestingly this latest dollar selling was slow and controlled until
Bernanke panicked in September 2007 and started
slashing interest rates. This
caused real rates to plummet and they have since been driven to -2% by the
end of January, the latest CPI data available. It is today’s dismal real rates
that have driven the USDX’s new all-time lows.
In light of this real rates
and USDX history, investors and speculators can game the dollar’s
fortunes in the coming months. A
new dollar bull is extremely unlikely until we see sustained, healthy real
rates. Based on the precedent
from the last dollar bull of the 1990s, I suspect 3% to 4% real is the level
necessary. Not only do real rates
have to get this high, but international investors have to believe rates will
stay this high.
Three developments would be
necessary to make this a reality.
The CPI would have to moderate and nominal T-Bill yields would have to
rise. And the Fed would have to
command enough global credibility so that investors believed it intended to
keep nominal yields high enough to support healthy real rates for a long time
to come.
On the CPI front, falling
headline inflation is unlikely no matter how much the government
statisticians try to hide it. Food
and energy prices are rising globally due to structural deficits, adding very
visible price pressure. And MZM
money is rocketing 15% higher annually guaranteeing
higher general prices. No one is
going to believe a falling CPI even if the government publishes it. In today’s price environment,
Washington simply can’t report a CPI lower than 2% or 3% if it wants
this index to maintain mainstream credibility.
On the nominal yields
front, the Fed would have to raise rates dramatically
from here. If the CPI stays at
4%, the Fed would have to raise rates an astronomical 400 basis points or so
to get real rates to 3%! At a 2%
CPI, the Fed would have to raise rates 200bp. In either case, the stock markets
would plummet and Bernanke and his cronies would
probably be tried for treason. No
serious rate hikes are going to be politically feasible in today’s
credit-crisis-ridden economy for many months to come.
And even if the Fed could
raise short-term rates to the 6% to 7% necessary to see 3% to 4% real returns
in short-term Treasuries, would it have any credibility? After Bernanke’s
disastrous pro-inflation performance running the printing presses so far in
his short term, would any investors believe he can be trusted? I really doubt it. We may need to see a new hardcore Paul
Volcker-type Fed chair before any investors trust
the Fed again.
Thus it looks like the kinds
of positive real rates necessary to drive a secular dollar bull are unachievable in the foreseeable
future. The US credit
environment is so bad, and inflation due to the Fed’s monetary growth
so extreme, that nominal rates can’t go high
enough to yield healthy real rates.
And if real rates stay low or negative, the dollar’s bear market
will only continue.
Since July 2001 our current
dollar bear has bled 39.2%. This
may seem extreme, but the USDX lost 52.4% in its last secular bear ending in
September 1992. A similar loss in
our current bear would yield a USDX level of 57.5! Ouch. This is another 22% lower from today’s all-time dollar lows! So in light of historical precedent,
there is plenty of room for the USDX to continue falling even from here.
As an investor I hate this
prognosis. It makes my blood boil
when the Fed declares war on me and tries to steal my hard-earned capital
through inflation and negative real returns on cash. Thankfully there is a way to fight
this central bank’s depredations.
By deploying capital in gold, silver, and precious-metals miners,
investors can multiply their wealth through this difficult monetary
environment far faster than the Fed can destroy it.
For a variety of reasons
explained in depth in our new March newsletter, I expect a major rally in gold and
silver stocks in the next few months.
As such, we have been aggressively adding trades in elite gold and
silver stocks. This real rates
and USDX research makes the case for this tiny sector even more bullish. If the dollar continues heading lower
as the Fed’s disastrous negative real rates suggest it will, this is extremely bullish for gold and silver even at today’s prices. And their miners will follow the
metals.
So subscribe today to our
acclaimed monthly newsletter to get ready
for this potential monster rally.
First-time e-mail-edition subscribers will get a complimentary copy of
our new March issue outlining the bullish case. Your paid subscription will start next
month. You can digest our logic,
mirror our real-world trades, and prepare for what is likely to prove an
incredibly profitable few months in precious metals.
The bottom line is the
prevailing real-rates trend has a huge
impact on the US dollar’s trend.
When real rates are healthy, international investors flock to the
dollar to enjoy these yields. But
when real rates are low or negative, investors flee from the dollar to avoid
suffering losses after inflation.
This makes perfect sense logically and is readily evident
historically. Real returns matter.
Today we are stuck in an
environment where the Fed insists on attempting to bail out real-estate
speculators. But as the
Fed’s 2001 attempt to bail out NASDAQ speculators showed,
artificially-low-rate campaigns always fail to accomplish their goals. They just prolong the misery. A major side effect of today’s
campaign is the falling US dollar.
Until the Fed stops this foolishness, the dollar bear will continue.
Adam Hamilton, CPA
Zealllc.com
Mars
7, 2008
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