Down, Down, Down? The US Dollar

By: David Chapman | Thu, Jun 14, 2012
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US Dollar Index
Created using Omega TradeStation 2000i. Chart data supplied by Dial Data.

If you thought you were looking at a roller coaster you might be right. With a real roller coaster it eventually comes to a dead halt at the bottom and hopefully with all passengers returned safely. With this roller coaster one can't be quite be sure where the bottom is nor whether all of passengers would be returned safely.

This long term monthly chart of the US$ Index has been adjusted in that it starts with the German Deutsche Mark. If any currency represents the current Euro it is the former German Mark. The Euro today makes up 57.6% of the US$ Index. The US$ Index did not formally start until 1985 so prior to that the German Mark has been used as a stand-in.

The chart overall has a long down trending look about it. The US$ Index has been falling in value now for a period of 41 years since US President Richard Nixon took the world came off the gold standard in August 1971. There were two periods of exception 1980 to 1985 and 1995 to 2001. But discussing these periods is not the purpose of this piece.

Note, however, how the low of April 2008 caught that long term downtrend line from the lows of January 1980. What is difficult to interpret at this stage is whether it has hit its bottom or whether the US$ Index will continue its long term down trend.

A symmetrical triangle is usually followed by a continuation of the trend that preceded it. Symmetrical triangles are therefore normally continuation patterns. However, sometimes symmetrical triangles can act as tops or bottoms as was seen with the bottom that formed from 1989 to 1996 for the US$ Index. That triangle had an upside objective of roughly 120.50. In July 2001 the US$ Index topped out at 121.29.

The question is this a continuation pattern that would break down with potential objectives down to 52.50 or is it a bottom reversal pattern that could have objectives up to 109.30. Given that an upside breakout would also require that the US$ Index break out of that long term downtrend line from the highs of 1985 the overall pattern would appear to have higher odds that the breakout would be to the downside. The key breakdown zone is currently found around 74.30. The upside breakout zone is currently near 87.10.

What the current US$ Index does not reflect is the growing power of the Chinese Yuan as a world currency. Currently the three largest economies in the world are the European Union, the USA and China. China is the fastest growing economy in the world and is predicted to surpass both the USA and the European Union in this decade at the earliest or early in the next decade. Together these three make up roughly 60% of global GDP. Yet the Chinese Yuan is not a part of the current US$ Index. If it were then it might push the value of the US$ Index lower than it currently is.

At one time the Chinese Yuan was generally fixed to the US$ from 1997 to 2004 at around 8.28 Yuan = US$1. Today that rate is around 6.36 Yuan = US$1 a 22% appreciation in the value of the Yuan against the US$ or the other way it has been a 28% depreciation of the US$ against the Yuan. Pushed and prodded by the US China has slowly revalued the Yuan up but at the end of the day the Chinese control the pace. The Chinese Yuan is not a freely convertible currency as is the US$ or the Euro or for that matter the Cdn$, the Japanese Yen, the British Pound and some others.

In 1997 the US trade deficit with China was around $50 billion. In the space of three years from 2003 to 2006 the trade deficit grew from $124 billion to $234 billion. In 2011 the trade deficit with China was $295 billion and based on the first four months of 2012 the trade deficit for 2012 with China could be around $275 billion. This huge trade deficit is a source of considerable friction between the US and China. China has been called a currency manipulator by the US.

At one time there was a symbiotic relationship between China and US. The US bought China's exports, thus the huge trade deficits, and China through the People's Bank of China (the central bank) (PBOC) bought US Treasuries and in turn that financed the huge (and growing) US deficit. Eventually PBOC held over $1 trillion of US Treasuries. But now the Chinese have effectively stopped buying US Treasuries concerned as they are about the huge US deficit and growing debt. China is concerned that the US would monetize the debt potentially causing huge losses to China.

China's holdings of US Treasuries have declined from a peak of over $1.315 trillion in July 2011 to $1.167 trillion in March 2012. It may be lower now. That is a decline of $148 billion. On top of that PBOC is rarely seen at US bond auctions now. This has forced the Federal Reserve to step in who are currently buying roughly 60 to 70% of all US Treasury bond auctions.

China is now in the process of creating a trade zone in Asia that will use the Yuan as the currency of choice. China and Japan are currently in the process of working out a bilateral agreement that would encourage the use of the Chinese Yuan and the Japanese Yen in cross border trade transactions. Russia and China are dealing cross border trade already in Rubles and Yuan. PBOC has already worked out deals with other Asian based central banks such as South Korea, Thailand and New Zealand that sets up holding Yuan denominated bonds as reserve currency.

As a result all participants could be bypassing the US$ as the currency of trade and decrease the amount of US Treasuries held in foreign exchange reserves. As well it is known that China and others have not bought into US sanctions against Iran. China will continue to buy oil from Iran and use Yuan and even gold. This is a process that breaks down the relationship of the US$ to the price of oil. India is using the Indian Rupee and possibly gold as well. Since SWIFT (the international payments system) is being blocked if one trades with Iran, China and India and others are turning to their own parallel payment systems.

All of this is considered an attack on the US$ as it reduces the US$'s importance in world trade; it reduces the US$ as a pricing mechanism for oil and other commodities; and, it is a direct attack on the supremacy of the US$ as the world's reserve currency. It could eventually lead to central banks holding fewer and fewer US$ as a part of their foreign reserves. This in turn has major ramifications for US$ debt much of which is currently held by foreign central banks.

And it lowers the demand for US$. With the US$ as the means to settle trade, trade between China and Japan as an example currently requires that if China buys goods from Japan, China sells Yuan for US$ and gives Japan US$ and then Japan sells US$ for Yen. Trade in their respective currencies would mean that the US$ is cut out of the transactions thus lowering demand for US$. But the supply of US$ has been nothing but growing sharply over the past few years as a result of programs such as QE and others to bail out the financial system. With supply growing and demand falling the US$ would logically have only one place to go and that is fall in price.

Transitions such as this are never easy. Effectively this is a currency war with the main combatants the US and China. The world has been through currency wars in the past. Germany challenged Britain and the supremacy of the British Pound as the world's currency in the late 19th and early 20th century. That confrontation ended badly with WW1. There were also a series of currency wars between 1921 and 1936 that became a part of the cause of the Great Depression and led to WW2 (outlined in detail in Currency Wars - James Rickards - Portfolio/Penguin 2011). A lesson is that behind every major war is an economic war and as well usually a currency war.

The US$/Euro is better known by everyone because the Euro is the prime component of the US$ Index. The relationship between the US$ and the Euro has been volatile. It has traded as high as $1.59 in July 2008 and as low as $1.10 in June 2010. The US also runs large trade deficits with Germany as the leading economy in the EU and with the EU itself. In 2011 the US trade deficit with Germany was $49.5 billion and with the EU it was $99.9 billion. These deficits are continuing into 2012 and are on pace thus far for a trade deficit of $53.4 billion with Germany and a $98.7 billion trade deficit with the EU. A falling Euro is therefore not in the US's interest. A weaker Euro has actually helped Germany particularly in its trade with the US.

Yet with the EU potentially coming apart at the seams it could unleash all sorts of chaos. A collapsing Euro is in no one's interest least of all the US. It is also not in China's interest as Europe is actually China's largest trading partner. That is why there appears to be support coming from the US to help bail out the European economies that are in trouble. China is also looking at providing support.

Greece collapsing and pulling out of the Euro is not the major problem as Greece is not that large a component of the EU. It is the contagion impact on Spain and Italy that is the real worry. The Italian economy is $2 trillion. Collapse of Italian banks could have global repercussions that impact financial institutions all around the globe but it would particularly negatively impact the European banking system but it would also negatively impact the US (and Canada) banking systems. Add to that the mountain of derivatives that could be negatively impacted and there is a real potential for a financial crisis that could surpass anything history has known.

Greece and Spain are already in depressions with official unemployment over 20% in both countries. Italy is slipping into recession and unemployment is growing. Austerity in Britain has hiked British unemployment. The same scenario most likely would be played out in the US and Canada. The worst case scenario is an economic depression in North America and Europe that could rival the Great Depression (1930-1939).

Combine that with the currency war between China and the US and the current military maneuvers around the China Sea and the military maneuvers with Iran and one could also get a shooting war. Accidents happen as history has shown. The assassination of the Austrian Archduke Ferdinand in 1914 triggered one of the greatest war slaughters in history.

The chart of the US$ Index is indeterminate right now. But with US$ supremacy being challenged by China the rhetoric that has been a part of US political scene in calling China a currency manipulator may only get louder particularly if the Republicans win the November election. In 2008 central bankers and the politicians worked out a rescue plan following the collapse of Lehman Brothers and that helped at least temporarily to stave off an even worse financial crisis. Today that is no longer true. In both Europe and the US the politics has become dysfunctional. And as for the central banks because of the financial crisis of 2008 they have a lot fewer tools left to be able to combat the growing paralysis and crisis.

As Jim Sinclair says it is QE to infinity. There is little else left. No wonder Sinclair (and many others) repeat that one should hold gold as a core asset as a result of the growing crisis. Gold is, as they say, headed for $2,000 and even higher as the financial crisis deepens.



David Chapman

Author: David Chapman

David Chapman

David Chapman

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