With all of the fervor over the US dollar index rallying close to 100, a reality check is in order. According to financial media reports the Euro is collapsing, gold is a barbarous relic that’s lust its luster, oil is falling and the commodity complex itself is imploding. Readers of this blog may remember that on November 1st of 2014 I wrote about the possibility that such a situation may play out in 2015.
Opportunities may exist in battered markets
Sentiment for other major currencies, energy, precious and non-precious metals could not be much worse than it is now. Cautious contrarian investors may find opportunities in the extreme negative sentiment. Certainly many natural resources companies have much more attractive valuations now than they did several years ago. Commodities themselves may also offer more value at these price levels than they did in previous years. Both as a hedge against inflation and a bet that resource consumption will increase in years to come.
Meanwhile US dollar trend followers may pile on to what appears to be a massive multi-year rally in the US dollar index or short other currencies, commodities and similar assets. There already exists an enormous amount of speculative betting on the dollar surging higher and other dollar priced commodities and foreign currencies tumbling. This positioning leads me to believe that we may be closer to a high in the US dollar rally than a base to move higher from.
Thus far the US dollar index on a long term technical basis appears to have made a series of lower highs and lower lows stretching back to the rally in the mid-1980s (see above chart) which began as a result of massive interest rate increases by the US Federal Reserve. In order to break this downtrend the index would have to rally beyond 120 and sustain itself there. Only then would I feel that the US dollar has decisively entered an uptrend. That has not happened yet.
The range bound US dollar index
As of the last 10 years we find the US dollar index trading within a range between 72 and 100 (see chart below) which may continue for some time if there isn’t an outside catalyst. Ultimately I believe the US dollar index is headed for a lower low when the current rally stalls further and then reverses lower.
One must remember that the US dollar index is a trade weighted currency basket that measures the dollar vs. the Euro, Yen, Pound Sterling and does not necessarily directly reflect the purchasing power of the US dollar other than when buying these currencies. In addition, the US dollar index has enjoyed its current rally largely on expectations of a widening interest rate differential between the US Federal Reserve and other central banks.
Will the September hike come to fruition? Is it meaningful?
The Federal Reserve has repeatedly delayed its much anticipated interest rate hike, setting expectations that such an event may occur this September — and only if economic data fits their ever moving target. Given the mix of economic data (both good and bad), combined with the backdrop of a significantly weaker Euro and the US dollar beginning to impact multinational companies earnings, I would be surprised if the Federal Reserve set its sights on a heightening cycle. Perhaps a few increases to placate the financial media. But a significant normalization of interest rates would likely have catastrophic effects on multiple asset markets, including mortgages, bonds, stocks and interbank financing.
Up until 2008 the Federal Reserve largely followed the US Treasury 3 month bill rate — rather than vice versa. This meant that interest policy was apparently largely set by the 90-day Treasury Bill market. See the chart above for a visualization of this trend.
Where there was once rate guidance there exists only volatility
Below you will find a chart of the 3 month Treasury bill rate graphed from 2000 to present. In that chart one can see that the same dynamic may no longer exist. That is to say that the 3 month Treasury bill rate is extremely volatile and has been since 2008. Is this an unintended consequence of quantitative easing and zero interest rate policy? Is the Federal Reserve now without guidance from this critical interest rate setting market? Or is the paradigm shift one where the Federal Reserve will now lead where the markets once did?
Much as the rate heightening cycle in 2004-2007 set off a powder keg of insolvencies related to highly leveraged speculative bets imploding, I believe any similar rate heightening cycle this time around will have equally disruptivbe, if not worse, consequences. But it’s anyone’s guess at this point. As you can see we are largely in uncharted territory.