by Bryan Rich
I’ve given plenty of arguments in my Money and Markets columns over the past couple of years as to why I think the pontifications about the dollar’s demise are greatly exaggerated. The fact is, the dollar is still with us! And it’s been trending higher against a basket of most widely-traded currencies since the global crisis erupted.
Make no mistake: I’m not a permabull on the dollar. I simply side with the evidence. And on a relative basis, given the scale of global economic problems, the dollar is still a front runner in the least ugly contest.
Here are three reasons why …
Money Is Moving Out
of Emerging Markets …
The wave of monetary policy tightening in the emerging market world is threatening a sharp slowdown in what has been a refuge of growth in the midst, and wake, of one of the worst global economic downturns on record.
With the writing on the wall, stocks in these markets have rolled over. Several have already visited double-digit loss territory for the year — including the likes of Chile, Indonesia and India.
And capital has moved away from these countries in favor of the developed markets — the precise opposite flow most experts were expecting for 2011. In fact, the weekly outflows in emerging market ETF’s hit record levels earlier this month.
With that, I think the dollar has the fuel to make its next leg higher. And I think it can go a lot further and extend a lot longer than many people expect. Especially when you factor in that the U.S. is expected to outgrow the UK, Japan and the euro zone this year by nearly 3 to 1.
Meanwhile market interest rates in the advanced economies have screamed higher in recent weeks, but the impact has not yet been felt in the dollar.
The Dollar Is Losing Merit
as a Funding Currency …
Both the Swiss franc and the Japanese yen were the most widely-used funding currencies when the carry trade (i.e. borrowing low yielding currencies to fund the purchase of high yielding currencies) was at peak popularity.
This is because, while most global short-term interest rates were near or well above 5 percent in the late stages of the global credit boom, interest rates in Switzerland and Japan were still closer to zero. And that made it most appealing to borrow Swiss francs and yen to fund highly leveraged carry trades.
But with other developed-market interest rates scraping along the bottom in recent years, there have been other alternatives to fund carry trades — namely U.S. dollars.
Now that is changing …
As market interest rates have risen across the board in recent weeks, and as the bond markets have begun pricing in more risk and more inflation pressures, so has the appeal of higher market interest rates in the U.S. — like a 10-year Treasury sniffing toward 4 percent.
Consequently, we’re seeing the early stages of the “carry trade of old” return. And this dynamic has been most clearly expressed in the dollar/Swiss franc and dollar/Japanese yen exchange rates.
The dollar has broken eight-month downtrends against both the Swiss franc and the Japanese yen. And given the Swiss exposure to European sovereign debt crisis and Japan’s problematic fundamental outlook, this trend break for the dollar could prove the early stages of a long-term trend change.
The Charts Confirm the Dollar
Is in a Good Spot to Buy
When we hear a report from mainstream media on how the dollar is faring, it’s typically a reference to the trading performance of the dollar index. While currencies are only valued on a relative basis, against the value of another currency, the index is a gauge of how the dollar stands against a basket of widely traded currencies — namely the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona and the Swiss franc.
You can see in the chart below that the cycles on the dollar index tend to last around 7 years on average. And based on this history, the cycles continue to argue the buck is less than half-way through a bullish cycle. To be sure, it’s been a choppy one.
But the dollar continues to trend higher, making higher lows along the way. And I think we can see a new high in this cycle this year. That’s 15 percent higher from current levels.
For more perspective, the following weekly chart going back to the failure of the Bretton Woods system shows the historic bottoming formations in the dollar over the past 40 years.
This chart is designed to look back and see what happened to the dollar in the past when the chart pattern looked like it does now. You can see the slope of this current uptrend (in the green box) is consistent with prior bottoms, particularly the bottom in 1978 (the white box), which initiated a big bull cycle in the dollar.
Finally, the next chart shows the last two, dollar cycles. You can see the key channel support for the dollar (the red channel), which presents an extremely attractive low risk/high reward place to buy dollars.
So when you add it up all the evidence, despite its naysayers, and the avalanche of challenges surrounding its future, the dollar is looking more and more appealing to global investors.
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