Dollar Rally the Sort of Thing that Will Lead to Correction in Gold Price

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So this is what it feels like in an inflationary melt up. House prices were up 6.2% in the third quarter over the same time last year, according to data from the Australian Bureau of Statistics. House prices in the capital cities are surging. Stocks are surging. Gold and oil are surging.

And counter to our prediction of an imminent, counter-trend U.S. dollar rally, the dollar is most definitely not surging. Take a look at the chart below. We’ve been writing about the decline of the dollar for nigh on ten years. So we looked at a ten year chart to tally up the damage. It is considerable.

Dollar Index Threatens New Lows

What’s at stake with the interpretation of this chart? If the dollar rallies on short covering from the dollar carry trade (a BIG if), then other “risk” assets like gold, stocks, and emerging markets would probably sell off. And yes Australian stocks, that includes you. As well as the Aussie dollar.

The chart shows that the index’s 50-week moving average is set to cross below its 200-week moving average. That is mixed news. The first time it happened on this chart was back in early 2003. That was the early days of a long decline in the index. The second time, though the move failed to confirm the “flight to safety” rally of 2008 had staying power in 2009.

Once the fear that gripped markets in 2008 went away, the investment world sold the dollar and started borrowing en masse to buy other, higher-yielding currencies and assets (like the Aussie dollar and resource stocks). That’s where we are now.

But based on the chart, is the next move down in the dollar index a new low, which the crossing of the long-term MA by the short-term MA would suggest? Or is it a false move? Will the dollar quickly and violently rally for some reason (geopolitical perhaps) that currently remains unknown to the human beings of this world?

“It’s an interesting chart,” said our technical analyst Murray Dawes. “But it is not useful for timing your moves out of or into trades related to the dollar’s movement.”

“So you’re saying our chart doesn’t have any useful information from a trader’s perspective?”

“Not really.”

Murray promised to show us HIS dollar index chart tomorrow. We’ll bring it to you, live and in colour. But in the meantime, we think the one piece of important information communicated by our chart is that the dollar’s trend is down. But there IS a catch.

The catch is that when this many people are this uniformly bearish, everyone is probably wrong. Consider this a warning then, that a dollar rally is just the sort of thing that will lead to a correction in the gold price and the stock market. We won’t speculate on the sort of things that could lead to a dollar rally. But surely they’re out there and sooner or later they’ll come.

The other possibility is that the dollar is in its death throes and that this is the big one, in currency terms. That is such a momentous and disastrous event that people consider it both kooky and unlikely, not to mention undesirable to a predictable and comfortable world. But it IS possible.

And do you get the feeling that this kind of manic melt up rally is the sort of irrational frenzy that comes just before everything goes haywire? Haywire is not a precise financial term. So what do we mean?

We meant that the world enjoyed a 20-year economic relationship based on a fundamentally unbalanced global economy. Manufacturing capacity migrated to Asia where wages were lower. For awhile, this was mostly good news in Western countries. Goods got cheaper but jobs didn’t vanish.

Now the situation is not so pleasant. The world is awash in manufacturing over-capacity, especially in China. Wage deflation (in the Western world) looks like a long-term trend, leading to a lower standard of living. This wage deflation is occurring at exactly the same time that Western governments are encountering demographic crises of ageing populations.

We all knew the ageing of the Boomers would put pressure on public finances right around now. But no one reckoned on a global financial crisis further saddling the public balance sheet with debt. And no one reckoned that Western wages and incomes would be falling at just the time people needed them most. And no one reckoned that savers would lose the most from low interest rates on fixed income – even though those low rates are keeping the American housing sector on life support.

It’s a bit of global impasse. America’s needed structural adjustment has come. Households and businesses are reducing debt, trying to live within their means. But the net adjustment to the American balance sheet is not happening because public sector debt is growing so fast.

Meanwhile, the other obvious adjustment is that the Chinese currency ought to be allowed to strengthen. For political and social reasons though, China will not allow this. It means China is actually adding to its industrial over capacity. It is conjuring up the world’s largest ever bubble in fixed asset investment, including commercial real estate.

It is easy to see why China is reluctant to allow a stronger Yuan. Exports account for 39% of Chinese GDP. The Chinese economy, and probably the Communist Party itself, cannot survive on unleashed Chinese domestic demand. They need American markets. But American consumers – in addition to reducing debt – are now realising that the focus on finance over manufacturing from American policy makers has worked out for Washington and Wall Street, but not terribly well for the average American worker.

Where do we go from here? How about the blame game. U.S. Treasury Secretary Tim Geithner once blamed the Chinese for being currency manipulators. He back-tracked later. And yesterday, Liu Mingkang, the chairman of the China Banking Regulatory Commission, had a go at America.

“The continuous depreciation in the dollar, and the US government’s indication that, in order to resume growth and maintain public confidence, it basically won’t raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation.” He is blaming the U.S. for fuelling a destabilising global bubble.

Of course that bubble is felt most acutely because China pegs its currency to the dollar. China is right to blame the U.S. for manipulating its currency to try and improve its competitive position. And China is right to worry about the value of its dollar-denominated assets in a world of exploding U.S. debt supply.

But China has put itself in this position. And here we are at the end of 2009 with a world still fundamentally un-adjusted to a new, workable currency arrangement. The world remains burdened by trillions in assets purchased with debt. Those assets linger on bank balance sheets, on government life support but fundamentally lifeless at fictitious book value prices.

And meanwhile, the China-US currency arrangement has fuelled a global bubble. Australia is part of this bubble, too. The question is how it will end. In the U.S., the housing market looms as the Achilles heel of the economy. It could strike households, banks, and the government again in the next 12 months are more mortgages reset at higher rates (with lower home values).

If the event that pops this bubble comes from America, look for the supply of credit to the emerging world to dry up again. And though Australia is not a developing economy, we saw last time what happened when U.S. credit markets imploded. Australian banks had to get a government guarantee to borrow money in the wholesale market.

We’d suggest that lending for residential housing and commercial real estate would take a real dip in Australia on another U.S. housing crisis (even if Aussie banks aren’t exposed to actual U.S. housing-backed RMBS and CDOs. You don’t have to own toxic debt to be impacted by it.

If the bubble pricking comes from China, what then? Well, China does everything big. So a Chinese bust would be world-class. It’s a subject that requires its own Daily Reckoning. More tomorrow.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. I agree completely Dan, when China goes bang it has the potential to be spectacular.

    Most people dont seem to ask the question how China is industrializing? Where is the government getting money to spend on infrastructure and where are the people getting money from to spend on computers and mobile phones? The answer to both is exports. Which no longer exists

    Two more warnings out today – the Chief Financial Officer of the largest scrap metals company in China resigned because he wasn’t allowed access to the financial documents – might be nothing but could mean something serious and when capacity is out of hand i think it could be the latter.

    The second is a slow down in consumption of oil in China. The reporter said the next few months normally sees a slow down in consumption of oil which might be correct. However, if car sales in China are increasing 76% a month that makes no sense.

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  2. mmmmmmm … I am a step to the side on some of these things. Firstly on China, the centrality of the issue lies with the domestic savings. You don’t make macro choices with consumer minds on a string when it comes to a cultural thing like saving for a rainy day if you are a Chinese or the shop til you drop if you are American. Even if the Chinese bring in a safety net, their people will be stubborn, and they don’t have a tyrant like Mao around to re-educate in another life the malcontents that don’t spend like the state might lately decide it wants them to.

    Next, this anti-mercantilist propaganda thing is always run by the fat and lazy. When we do business we have one set of values and strive to win, but as a nation we ask that they shoot themselves in the foot to save those that won’t lift their productivity and innovation. And if nobody gets to win in a mercantilist sense then what do we aspire to? The standard 20th century answer was to cut them down and steal their knowhow. Use a weight of numbers in the production side after cutting off their supply lines to draw them into battle and then grind and gun them down.

    And on this dollar thing again. It is about credit … USD credit. Risk is when the credit is expanding in the US. It has nothing to do with what fundamentals happen elsewhere where that USD might land (commodities countries, equities). And all the while since the Vietnam War the USD drifts down and strains against any standard it is held to. But when global reserve currency originated credit contracts then the USD will appreciate as deleveraging occurs. Notice I’m not even talking about the carry which I consider a poor cousin, yes it is amplified by too low USD borrowing rates but the fundamental base is the shovelling out the door of bodgy lending, the mispricing of risk, the off balance sheet vehicle baloney, the derivative wash on risk with phoney counterparties that can never carry the can when any bubble anywhere hits the fan.

    And new things are happening I reckon. I had this hunch that the carry was in trouble with the Brazilian tax knocking out too much corner from the sweet little penny lane tune narrative. I am seeing that the CBA PERLS mezz hybrids have hit a wall in the past weeks, and then days later the CBA common stock and the whole XXJ index has started to follow it down. And it predated Miss Meredith on CNBC questionning bank stock valuations. Put the XXJ against the XJO or the XMJ and you will see a clear divergence that we haven’t seen for some time.

    Perhaps GS has finally worked that any likely IAS standard and Aussie banks are mutually incompatible? But more likely perhaps the whole sector has hit an Obama with more backbone than expected and the FASB mark to market “out” is really going to close on 1 Jan. And that means deleverage and an unwinding of the carry despite their keeping rates at zero?

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  3. Why doesn’t the Chinese government hand out the equivalent of Harvey Norman vouchers???

    Shop vouchers have an expiry date and can’t be saved like cash, so it would force the Chinese to actually spend their money….

    Reply
  4. Good work Winkinatcha.
    I tend to favour against dollar rally…even though its on cards once again. Been waiting for a freefall in dollar between here and somewhere below the 08 low. Maybe bigtimers running stops before the big move down? Or maybe just putting a bit more braking power under the slide…scaring off a few shorts, commod longs etc?

    Lachlan Scanlan
    November 21, 2009
    Reply

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