Why the US Dollar is Rallying

By: Christopher_Laird

Back in April, we alerted subscribers that the USD appeared to be bottoming. At the time, it was floating at about 70-72 on the USDX. A whole lot has happened since then to cause this reversal, with the USD now at 78 plus on the USDX (US dollar index currency basket heavily Euro weighted). There are many reasons for the rebound of the USD and its rise is likely to continue. Many of the long term trends that acted since 2002 to weaken the USD have reversed. The exceptions are the continuing US trade and fiscal deficits, but those USD bearish forces are being overridden by these other big bullish USD drivers that have now appeared in 08.

Let's make a list of the USD bullish drivers:

• The US economy fell into recession starting in 07. As the other economies now slow, their currencies fall, while the USD had already done its falling on the initial recession concerns. This makes their exchange rates to the USD fall.
• The present turnaround of the USD goes back to the time it started its big drop, that is from around 2002, when gold was at a bottom. What this means is that if the USD is rising due to factors reversing that had been in place since 2002, the USD can rise a good bit and also for a good while.
• The commodity bull market since 2002 has probably peaked in mid 08 (its way down from the highs this year). The factors that drove the commodity bull market are also big long term forces and they are all reversing, hence commodities correct, and likely will continue to correct.
• The Euro rose a great deal since 2002 vs the USD and that is now reversing, which means the Euro has a good way to correct from here. That is very USD bullish.
• The EU economies are slowing rapidly, even crashing (Spain, UK, Club Med, Baltics), that is cutting the ground from the Euro. The housing bubbles there are now crashing.
• The Asian economies are slowing quickly, and even China is acting to support their stock markets that have crashed 60% in the last year. That is hurting commodity fundamentals. Weaker commodity prices are deflationary in general, and that is USD bullish. (I want to point out something here. When there are big swings in a market from a long bull to a bear, typically the market analysts are the last to admit the change from bull to bear as they have been so caught up tracking the bull for years. We try to consider this, and here, think it's time to start considering that the multiyear commodity bull market that attracted speculators is now turning decidedly).
• The speculators that had piled into commodities are now realizing that party is over, and considering that they had been hanging out in commodities for several years, that means a lot of them want to get out but can't do that too quickly or they crash the prices and take losses. They are stuck. But they are going to continue selling.
• The US is likely done with interest rate cuts, having led the pack in 07 cutting rates to 2%, while the ECB is going to have to start to cut and traders are bidding the USD up and the Euro down on that expectation.
• The ECB is losing patience supporting markets and financial institutions as, this week, it started restrictions on taking the bad collateral from banks ‘abusing' that. That adds to overall deleveraging and flight to cash.
• Pimco's Bill Gross just stated that the US treasury needs to act quickly to support the markets or there will be a ‘tsunami' of deleveraging in all financial markets as funds are now finally starting to bail out, realizing that there is likely no recovery of the US economy. They had held out hope since 07 for that recovery, but that is now clearly not in the cards. So they are bailing out. Deleveraging is USD and carry trade currency bullish.
• There is a lot of general deleveraging in markets and in credit markets. A lot of big investors are going to cash and quality sovereign bonds, such as US treasuries, and this demand for cash is strengthening the USD and the US treasuries.
• Financial institutions are again hoarding cash in the US and the EU. While this is bullish for both currencies, the USD is benefitting more than the Euro. That is going to continue through the end of the year. This cash hoarding occurred in 07 in the last quarter. At that time, the USD strengthened several points on the USDX during that time. The way the USD is going now, already over 78 on the USDX and this being September, the USD can easily breach 80 and higher on the USDX by the end of the year because of the cash hoarding.
• Money is coming back into the US from the formerly hot foreign markets, as people realize that party is over. Also, there is capital investment coming back into the US as EU manufacturers seek to move production to ‘dollar zones' as costs are too high in the EU with the strong Euro. Asian manufacturers are also moving money back to the US and moving manufacturing here because of a cheap USD and also high fuel/energy costs which are said to be a bigger part of their costs than actually making the stuff.
• There is capital disinvestment in the EU region and that is Euro bearish.
• A lot of speculators are now reversing their former USD bearish trades they had for years.

Most of these huge macro trends, that are USD bullish, became clear this year. Hence, the USD rallied from 70 on the USDX to 78, an 11.4% increase in only a few months since April. While it's possible the USD could correct a bit within that range, it appears the USD is headed higher, and for a while too.

Stronger USD means commodity correction

This means that the commodity correction is likely to continue and precious metals likely to continue their correction to levels that were concurrent with the USD in the 80's on the USDX. This would place gold in the $600 to $700 range. Remember, gold is a foreign exchange asset and central bank reserve asset, and should be considered in that context. Its primary valuations are based on currency exchange rates. The speculative froth in gold is exactly that, froth, and not a primary gold driver. This is why we have told subscribers to look at gold as savings and not to demand big gains, but to see gold as savings. The speculative froth in gold comes and goes.

One caveat on that gold price is if there are any new serious credit meltdowns. The credit crisis was a primary driver for gold to rise from $660s in August 07 to over $1000 this year. And, as always, a war in the Mid East would be super gold and oil bullish.

Again, we point out that while the USD has terrible fundamentals related to the US trade and fiscal deficits, the other gold bullish factors we list above are overriding those bearish deficit factors at this time. These present USD bullish factors are very big macroeconomic drivers, and are big changes from recent years. That means the USD can rally and stay rallying for a good while.

We believe that precious metals should be kept against a USD devaluation event that will likely happen within several years, but for now the USD rallies, and has good reasons to rally for the present.

By Christopher Laird
PrudentSquirrel.com

Copyright © 2008 Christopher Laird

Chris Laird has been an Oracle systems engineer, database administrator, and math teacher. He has a BS in mathematics from UCLA and is a certified Oracle database administrator. He has been an avid follower of financial news since childhood. His father is Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He has grown up immersed in financial news. His Grandmother was Alice Widener, publisher of USA magazine in the 60's to 80's, a newsletter that covered many of the topics you find today at the preeminent gold sites. Chris is the publisher of the Prudent Squirrel newsletter, an economic and gold commentary.

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