The Long-Term Dollar Bear

Here is an extract from commentary that was posted at www.speculative-investor.com on 15th December 2002. 

Last Thursday it was reported that the US current account balance for the 3rd quarter of this year was a deficit of $127B, about the same as the all-time high reached during the second quarter. Despite this huge out-flow of money from the US each quarter, the US Dollar Index has only fallen by around 15% from last year's major peak. Dollar bulls say this is a sign of US strength (the bullish argument is that the current account deficit is a result of the enormous foreign investment demand for US Dollars and that this demand is likely to persist). Others argue that the US$ remains relatively firm by default, that is, it hasn't collapsed because the main alternatives - the euro and the Yen - are unattractive. Both arguments are wrong.

The massive US current account deficit hasn't led to a massive decline in the US$ yet because we are still in the early stages of a new cycle. As sure as night follows day (well, maybe not quite that sure) the US$ will continue to fall...and fall...and fall...until the US current account moves back into surplus. Based on where we are today it is difficult to believe that the US will ever have a current account surplus again, but it will happen. 

Below is a chart comparing the US quarterly balance on current account with a trade-weighted index of the US Dollar's exchange value relative to other major currencies, beginning in 1973. The shaded areas on the chart cover the periods from major US$ peaks to major US$ troughs. Prior to last year there had been 2 major peaks since 1973 - one in early-1977 and one in early-1985. In both of these cases the preceding uptrend in the Dollar had been accompanied by the current account moving into deficit. In 1977 the current account deficit was small and it only took a 16% fall in the US$ over 2 years to bring the account back into surplus. In 1985 the current account deficit was much larger and it took a 40% fall in the dollar over 6 years to bring the account back into surplus. In both cases the current account moved further into deficit during the initial phase of the dollar's decline and in both cases the dollar continued to decline until the current account had moved into surplus. 
 

We can't think of any reason why it is going to be different this time. From a long-term perspective we should therefore remain bearish on the US$ and bullish on those things that benefit from a weaker US$ (e.g., gold) until the US current account has moved back to a surplus. Furthermore, given that the present deficit is far greater than anything seen in the past it is likely that the dollar bear-market that began last year will result in a drop, from peak to trough, of substantially more than the 40% drop that occurred during 1985-1990.

The Dollar's bear market is probably going to extend for many years, but as is always the case during any long-term trend there will, from time to time, be substantial counter-trend moves. In other words, if we are right that the US$ has embarked on a long-term bear market there will still be periods, possibly quite lengthy periods (6-12 months or longer), during which the Dollar will trend higher and those investments that benefit from a weaker Dollar will trend lower. 

As mentioned in last week's commentary the currency market is presently set-up for a US$ selling climax to occur over the next 1-2 months, after which a large counter-trend move would become likely. Our current medium-term target for the Dollar Index, a target that was first broached in our 2nd October commentary, is the 1998 low of around 90 (see chart below). We expect the Dollar to reach this target by the end of March next year and wouldn't be surprised if it were reached as early as next month. We will, however, need to be alert to the possibility that support defined by the 1999 low will hold. 
 

In our 2nd December commentary we said "gold stocks [are expected] to provide the early warning signal because gold is likely to move in advance of breakouts in the CRB Index and the Dollar, and gold stocks are likely to move in advance of gold." We were referring to the likelihood that gold stocks would break out to the upside ahead of an upside breakout in the gold price, which would, in turn, occur ahead of an upside breakout in the CRB Index and a downside breakout in the Dollar. We expect gold stocks to show similar leadership near the end of the current gold rally and dollar decline, that is, gold stocks should turn lower prior to a peak in the gold price and a bottom in the US$.

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