Written by the BullBear Analytics team
In our last article, we discussed the China example of the global carry trade that’s looming large in the world today. This article will be setting up a discussion of the international currency pricing system, which will be discussed in full in our next article. Today, however, we wanted to zoom out from China and take a thorough look at the global carry trade unwind as a whole, and what the possible implications are of this move on our US dollar forecast.
The absence of U.S. dollar inflation seems counterintuitive considering the Federal Reserve has printed over $1 trillion, and injected it into the economy. Despite their best efforts to get inflation, the Fed is facing a massive headwind. We believe there is an embedded short that global investors are scurrying to cover right now. This short squeeze is soaking up all those printed dollars, which is actually producing deflation – the opposite of what was intended.
To illustrate what we mean, let’s start by taking a look at the velocity of money charts below. The velocity of money is a measurement of how many currency units – let’s say dollars – are being exchanged in an economy. M1 is the money supply of currency in circulation, and M2 is M1 plus saving deposits, certificates of deposit, and money market deposits for individuals. From the Fed:
“The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy. The frequency of currency exchange can be used to determine the velocity of a given component of the money supply, providing some insight into whether consumers and businesses are saving or spending their money.[1]”
So, despite the U.S.’s massive monetary base expansion the amount of money being transacted in the economy has actually decreased dramatically, which is definitely NOT inflationary. As further proof, let’s turn our attention to gold.
Has King Midas Lost His Touch?
A good measure of the level of inflation that exists in the world is the price of gold. Gold has historically been a safe haven as a stable store of value during inflationary times. Yet, the price of gold has taken a severe beating in dollar terms despite the fact that the monetary base has been expanded all over the world. Japan, Europe, and the U.S. have all printed massive amounts of money, and are barely (if at all) meeting their inflation targets. On top of that, many countries including the ones listed above instituted zero or negative interest rate policies (ZIRP and NIRP) in an effort to spur inflation, but with little success.[2]
As you can see below, the S&P 500 piggybacked on the dollar’s ascent, while gold has come crashing down to earth. This isn’t the typical gold behavior in a world where money is being printed out of thin air at a rapid pace (see Weimar Republic).
So what is going on, here? The most important part of the chart above isn’t the price of gold – it’s the dollar’s ascent. In my last post, I briefly mentioned that credit extended to non-bank borrowers since 2009 has ballooned to between $6 and $9 trillion![3]
A Fistful of Dollars
The world has seen a tremendous amount of dollar-denominated debt issued since the financial crisis of 2009. With interest rates being cut to near zero all over the world, investors went on an expansive (and expensive) borrowing spree looking to make money on carry trades. They have been borrowing from Japan and the U.S. especially, and investing in places like China and other emerging markets.[4] When growth in places like China has an epic slowdown like it has recently, these types of risky investments tend to blow up hastily.
As growth began to slow in emerging markets around the world some years ago, investors began closing out their carry trades causing a rapid surge in the dollar. This only served to exacerbate problems in emerging markets as capital outflows led to severe inflation of the domestic currencies. I’m going to run through several charts listed below to illustrate this point.
This is the U.S. Dollar Index. Commonly referred to as the DXY, this index measures the value of the dollar against a basket of six major world currencies: the euro, Japanese yen, Canadian dollar, British pound, Swedish krona, and Swiss franc.[5] We’ve seen a 20% increase since 2014 with a pretty clear cup and handle set up – usually a bullish indicator.
Below is a zoomed-out picture of the U.S. Dollar Index. You can see that the 30 year trend line has clearly been broken. The cup and handle we saw above is sitting right on top of that 30 year trendline.
It looks worse when we see the Trade Weighted U.S. Dollar Index. This index tracks the dollar against an even larger basket of currencies - the Euro Area, Canada, Japan, Mexico, China, United Kingdom, Taiwan, Korea, Singapore, Hong Kong, Malaysia, Brazil, Switzerland, Thailand, Philippines, Australia, Indonesia, India, Israel, Saudi Arabia, Russia, Sweden, Argentina, Venezuela, Chile and Colombia.[6] The dollar is absolutely crushing most of these emerging and frontier market currencies.
Brazil
Let’s look a little more closely at some specific examples. First, Brazil’s real has fallen over 90% relative to the dollar as one of its major exports – copper – has massively declined in price over the last couple of years.
Chile
Another country suffering from the dollar bull market is Chile with pretty much a mirror image dollar appreciation relative to the Chilean peso vs. the decline in the dollar price of copper.
Australia & Canada
Obviously, these are just microcosmic examples of a common trend in the macro environment, however they are meaningful in unison. Quickly turning to oil, we all know how this story ends.
Australia and Canada are just a couple of the oil-dependent economies that the rise of the dollar and the subsequent oil price decline has affected…
Rounding the Edges
As investors have rushed to close their carry trades, they inadvertently soaked up those QE-printed dollars. This has cancelled out the inflation economists in the U.S., Europe, and Japan were hoping for. As a side note, this is probably the main reason gold and silver have under-performed expectations as of late. With the dollar surging, large institutional investors have closed out their gold and silver positions in exchange for cash while at the same time shorting the metals. But that’s an article for another time.
In our next article, I’d like to discuss why the dollar bull market is just heating up. I’ll be covering how the international pricing system is set up such that small moves in the dollar value create exponentially larger problems in global markets. I’ll be talking about the Fed’s latest rate hike, and how more hikes could flatten global markets. In fact, instead of more rate hikes, I’ll go over a more likely scenario – QE4.
[1] https://research.stlouisfed.org/fred2/series/M1V
[2] To government sponsored economists, inflation = growth.
[3] http://www.bis.org/publ/work483.pdf
[4] For a thorough overview of the dollar carry trade, this is a fantastic educational video from the Founder of RealVision TV and Global Macro Investor, Raoul Pal: https://www.youtube.com/watch?v=JK_cc_1UNT0
[5] The index started at 100 back in 1973. To help you conceptualize its mechanics, if the DXY were to reach 110, it would mean that the dollar had increased 10% in value relative to the other currencies in the basket. http://www.investopedia.com/terms/u/usdx.asp
[6] https://research.stlouisfed.org/fred2/series/TWEXB
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