Tuesday 25 February 2015
“The mind of the past is ungraspable;
the mind of the future is ungraspable;
the mind of the present is ungraspable.
- Diamond Sutra
Commentary & Analysis
US Dollar Life Cycle
Here’s our simple model, not original, which represents our view markets represent mini- and major-boom bust cycles driven by various rationales of real players which are consistently flawed. The big question is: Where is the US dollar, in terms of its bull market, along this scale of boom-bust?
Before we try to answer that question, let’s consider the past cycles in the buck.
Long-term trends in the currency markets have ranged from six to ten years, measured by the various bull and bear markets in the dollar since the inception of the free-floating currency market back in 1971. Here’s the pattern of long-term bear and bull markets in the dollar as measured by the US $ Index:
1971-1978: Seven-year bear market (President Nixon closes the gold window closed)
1978-1985: Six-year bull market (Fed Chairman Volcker squeezes inflation)
1985-1992: Seven-year bear market (Triggered by the Plaza Accord)
1992-2001: Ten-year bull market (Tech boom and money flow to US assets)
2001-2008: Seven year bear market (bottom on the credit crunch)
2008- ? : Next major bull market?
The dollar, especially from a longer term perspective, moves in waves—discernable waves based on human emotion and supported to differing degrees by the underlying economic fundamentals at various stages along the way. It sounds complicated but it’s not. Here’s an example of the waves or stages of the dollar in a boom/bust price cycle…
• Stage 1: The unrecognized trend – This is the early on stuff. It represents the beginning of a new trend that is recognized by only a few of the major players.
• Stage 2: The beginning of a self-reinforcing process – This is the stage where the consensus begins to realize there are real underlying fundamental reasons why this “new” trend has legs. This is the most powerful and longest leg or wave of the trend.
• Stage 3: The successful test – This is the pull-back that challenges the consensus view, it represents a significant retrace of the prior wave “self-reinforcing” wave. In the case of the dollar, the bear market correction we witnessed during 2005 is an example of a “successful test.”
• Stage 4: The growing conviction, resulting in a widening divergence between reality and expectations – This represents the last major leg or wave of the trend. It is supported by real fundamentals or expectations of how the fundamentals will play out, but it also represents the stage in which the currency is either “overvalued” or “undervalued” on a pure fundamental basis.
The best recent example was the leg-up in the British pound during the credit-induced bull phase. It was supported on strong growth in the UK economy and an aggressive Bank of England. But on a purchasing power parity basis (a key long-term indicator of real value) the pound was extremely “overvalued,” relative to the US dollar. But that didn’t mean the move was over. We still have the climax stage before the bull phase ends.
• Stage 5: The flaw in perceptions – This is the stage in the cycle when some of the major players begin to realize the currency cannot be supported by the fundamentals, as highlighted above.
• Stage 6: The climax – This is the final stage of the move, and represents the “overshoot” we often see in currency markets because they tend to be more sentiment driven and price-led than other asset markets.
• Stage 7: A self-reinforcing process in the opposite direction – The trend begins in the opposite direction.
We have always dated the beginning of the US dollar bull market from March 17th, 2008 which was, not coincidentally, the same day the US government “saved” Bear Sterns. Needless to say, that bullish call was early and hairy, given the deep corrective pull-back in 2011, as you can see in the weekly US dollar index chart below:
My guess it this:
- We are into the “conviction” phase of this dollar rally; and it has legs. The rationales have become somewhat clear for all to see: money flow to the US on rising yield differential (hot money) and capital appreciation (foreign direct investment). But this reality seems to have more juice to it given the growing divergence between the monetary policy of the Fed and other global central banks.
There will be corrections along the way. And the significant correction will come when the major players realize there is a flaw in the money flow expectations, i.e. rising yield differential and increasing foreign direct investment.
I don’t believe we are close to that yet.
Given the question marks still concerning euro viability (Greece will be back to the table in June and the not so dirty little secret is Greece has a solvency issue, not a liquidity issue), growth concerns in Asia (Abenomics jury still out and China slowdown seems for real even discounting crisis), and continued real money flow to the US by energy intensive companies looking for lower cost manufacturing; there seems more juice left to drive the dollar higher in the years ahead (a 10-year bull market in the US dollar carries to 2018).
Of course, the near-term dollar risk is a growth rebound in the Eurozone. And there are signs a recovering is building underneath the surface; though far from robust. Added to that the signals from equity fund players they are taking some off the table in the US and finding bargains in European equities. This could be the rationale for a pull-back in the dollar.
But of course, a better growth environment in Europe allows the Fed to be more aggressive; that in itself brings the rising yield differential back into play. This is the ebb and flow stuff we can only guess about.
All a guessing game indeed it is. It is never easy. But at least if we have a framework more closely based on market behavior of the real players who move money, and don’t just talk about it. I think it helps.
President, Black Swan Capital