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The Case For a Rising Dollar, Part III: Practice


by Michael Nystrom
July 13, 2006
Cambridge, MA

Read Part I here
Read Part II here


Based on Parts I, and II of this series, and my thoughts over the past few days on the subject of a rising dollar, here is how a rally in the dollar could unfold in practice:

Overly Bearish Sentiment and the New Guy from Goldman

Bearish sentiment on the dollar seems nearly unanimous. This in and of itself is enough to set the buck up for at least a temporary rally. Now, Bush has appointed a(nother) former Chairman of the most powerful investment bank in the world, Goldman Sachs, to head the US Treasury. Clearly, Bush is done messing around with his ineffectual cronies O'Neil and Snow in that office, and now he means business. Henry Paulson, as the President put it, "has a lifetime of business experience and an intimate knowledge of financial markets."

Intimate knowledge. Hmm…That should come in handy. Maybe Paulson can get on the horn with former Chairman of Goldman Sachs who also once ran the Treasury, Robert Rubin. Rubin of course, was officially famous for his tenure under Clinton during the go-go late 90's, when the dollar was strong and gold was weak and the Strong Dollar Policy was the order of the day. Unofficially, Rubin was infamous for being heading the Gold Cartel that kept the dollar strong precisely by keeping gold weak:
The Gold Cartel--the United States government, some other central banks and the bullion banks like Goldman Sachs and J.P. Morgan Chase--rigged the price of gold in the mid-1990s. It started with [former Treasury Secretary] Robert Rubin and the strong dollar policy. To help rig the price, in clandestine fashion, [several large banks] borrowed gold from the central bank and leased it into the marketplace without telling anybody--this was the gold cartel.


With Goldman Sachs back at the controls -- er, Paulson, I mean -- perhaps the Administration can figure out how to get the Gold Cartel back under control and get those pesky gold prices down. No doubt that's what they've got in mind.

(I highly recommend the above article, and here is another great reference on the Gold Cartel by Jay Taylor

Even if you scoff at such "conspiracies," there is plenty of other (short term) bullish news for the buck:

Improving Fiscal and Trade Figures

On the economic front, we have a surprise announcement that Federal budget deficit is shrinking, thanks to faster than expected increases in tax revenue. Forget for a second that the deficit is still HUGE and GROWING, the news is being spun as a positive, and that's what matters in markets - emotion, not reason. Whew! The budget deficit is only $128 billion this year! What an improvement! Let's hear it for fiscal responsibility! BUY! BUY! BUY!

On the heels of this comes news that US exports are increasing, meaning that if the trade deficit is not exactly shrinking, neither is it expanding as fast as expected.

In all seriousness, the job of the market is to price in the future, and from the perspective of the budget and trade deficits and therefore the dollar, the future just got a little less bleak.

Increasing Global Hostilities

On the war front, as we look out at the world, it seems there is nothing but trouble: More bluster and posturing in Iran, North Koreans launching missiles, Japan for the first time in post war history mulling an attack, terrorists bombing trains in India, Israel bombing Lebanon, and the US blaming Iran and Syria for making Israel start the war. The world is a powder keg that is getting hotter and drier by the minute. It is nerve-wracking and scary and clearly the markets don't like it.

Increasing Global Interest Rates and Risk

One reader of the previous article suggests that "the biggest factor affecting exchange rates is the interest rate differential between currencies. Hence, an intermediate term dollar rally is not out of the question." As it stands, nearly every industrialized country in the world is hiking their interest rates. Japan, the global font of liquidity will make its decision regarding rates this week, and we'll know their decision bright and early Friday morning. It is likely that the celebration traders had over the Fed's "final" rate hike may have been premature, since the Fed will have to keep pace with the world.

As world borrowing costs increase, speculation decreases (for what else do people do with borrowed money in this modern day and age but to use it for specualation?) Liquidity gets sucked out of the system, markets fall and the money runs home to safety. Between the wars, rumors of wars, and weakening markets, money gets scared and runs back to where it feels safest -- that old standby the U.S. dollar.

One reader suggests:
If I had to make a bet on a currency collapse, let me suggest that Europeans are also losing millions of manufacturing jobs and some of those countries may repudiate the Euro and their GATT obligations to try to shore up their economy. That would be a formula for a dollar rally. I am surprised it hasn't happened yet. The next recession may set the stage. . .
Short Squeeze.

To top it all off, since it has been so "clear" for so long that the dollar has but one direction to go, so many traders are already short, licking their chops and counting their gains.

As another reader put it:
[Nystrom] has the right insight on this. There will be many very large investors "trapped" in their bearish positions. Once the short covering begins, the move may develop legs, much like the rally in stocks until May. The reason is that it will take a long time to extinguish the bearish sentiment and it will be the bears providing the liquidity for the rally, not the fundamentals.
In a nutshell, we have:
  1. Overly one-sided bearish sentiment against the dollar
  2. A new Goldman Chairman heading up the Treasury with inside dope on the workings of a "strong dollar policy"
  3. Improving trade and budget deficits
  4. An unstable world lumbering towards war, creating financial uncertainty
  5. Rising global interest rates, including in the US
  6. A still-positive US interest rate differential which makes US dollar investments attractive
  7. A potential short squeeze if the dollar starts to rally
Put it all together and I think there is a decent case for an intermediate term rally. And while I wouldn't necessarily put my money on the dollar (oh, wait a minute, I guess all my bank and stock accounts are denominated in dollars) - I wouldn't bet against it, either. At least not yet.
The US has a gun to the head of every central bank we do business with. No central bank wants to find out what would happen if the dollar collapses against most currencies. So far that has not happened and it probably won't in the foreseeable future. Economic Armageddon is not an attractive prospect.
Final Caveat

By the way, and I think I mentioned this before - the long run prospects for the dollar are not good. In this series of articles I do not mean to imply anything more than a temporary rally for the dollar, staving off collapse for perhaps a year or so. The dollar has already proven itself not to be suitable as a long term store of value, and I doubt the dollar will ever get back to its all time high.

And just because the dollar rallies does not mean that gold must decline. If they begin to moving up together in unison for an extended period of time, it means that gold is challenging the dollar for the title of global reserve currency. If this begins to happen, we will have another clue that something fundamental about the world we know is changing.

Read Part I here
Read Part II here


As always, comments are welcome

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