Dollar euphoria and gold
The US dollar has rocketed higher since early November’s US presidential election, rivaling the massive gains seen in the stock markets. With the world’s reserve currency catapulted to extreme secular highs, dollar euphoria has naturally exploded. Traders are overwhelmingly betting the dollar’s strong upside will continue. But this greed-drenched currency looks very toppy and ready to fall, which is very bullish for gold.
The US dollar’s recent stampede higher has been amazing, as evidenced by the venerable US Dollar Index. Launched way back in 1973, the USDX is the dominant and most-popular market gauge of how the US dollar is faring. Since Election Day 2016 alone, the USDX has soared 5.1% higher in merely six weeks! That isn’t much behind the flagship S&P 500 broad-market stock index’s 5.9% post-election rally.
But the post-election USDX surge is still far more extreme. The world’s handful of reserve currencies are decisively commanded by the US dollar. Because of the vast amounts of dollars flooding the globe, it has great inertia. Thus like an oil supertanker, the dollar’s moves tend to be gradual and unfold over a long time. The USDX usually moves with all the sound and fury of a tortoise, leisurely meandering around.
The dollar’s normal lack of volatility helps explain why leverage on currency trading can be so epic, over 100x in some cases! To translate USDX moves into stock-market equivalents, they probably need to be multiplied by at least 3x or so. The dollar’s post-election surge is every bit as extreme as a 15%+ rally in the S&P 500 over six weeks would be! Such a colossal move has major implications for many markets.
Trump’s surprise victory unleashed staggering US-dollar buying on Fed-rate-hike expectations. Like all traders, the currency guys assume Trump’s proposed slashing of tax rates and regulations will help fuel a much-stronger US economy. That not only gives the Fed cover to hike rates faster, but could spark surging inflation that forces the Fed’s hand on rate normalization. It all boils down to Fed hawkishness.
This was reinforced at last week’s FOMC meeting, where the Fed met market expectations to hike its federal-funds rate for the first time in a year and just the second time in 10.5 years. Accompanying every other FOMC meeting, the Fed releases a Summary of Economic Projections. Currency, stock, bond, and commodity traders eagerly look to part of that report known as the “dot plot” to divine where rates are heading.
This dot plot is a graphical summary of where each individual FOMC member and regional-Fed president expects the federal-funds rate to be in each of the following few years. Since these are the guys who actually set monetary policy, traders heavily weight their collective outlook. Last week the newest dot plot pegged the number of rate hikes expected in 2017 at three, well above the two forecast a quarter earlier.
So the USDX took off like a rocket on higher expected US interest rates, soaring 1.0% on that Fed Day and another 1.0% the next! That monster 2.0% USDX gain made for its biggest two-day rally by far since late June in the immediate wake of that surprise Brexit vote. And it vaulted already-major dollar euphoria up to nosebleed extremes. Currency traders are totally convinced the dollar’s gains are only beginning.
Their premise is simple and logical. Higher prevailing US interest rates courtesy of Fed rate hikes will make US investments including cash, stocks, and bonds relatively more attractive to foreign investors in this low-yielding world. So they will increasingly sell their local currencies and migrate that capital into the US dollar to buy US investments. Currency traders think they are front running a massive coming shift.
This idea that higher US interest rates built on the foundation of the federal-funds rate lead to major US dollar buying seems unassailable. But why not see what history shows, how the USDX fared in the last Fed-rate-hike cycle? This first chart superimposes the US Dollar Index over the Fed’s federal-funds-rate target over the past 17 years or so. Surely Fed rate hikes fuel major bull markets in the US dollar, right?
Our current young Fed-rate-hike cycle is tiny, and technically not even a rate-hike cycle yet since there haven’t been three consecutive hikes. Nevertheless let’s take the Fed at its word and assume more rate hikes are coming before any cuts. So far we’ve seen two hikes totaling 50 basis points in the 12.2 months since last December. Indeed the USDX has rallied 4.9% over this new rate-hike-cycle span, a big move.
But that’s fairly misleading. From the day before the Fed’s first rate hike in nearly a decade a year ago to Election Day, the USDX actually slipped 0.2% lower! The dollar hadn’t strengthened one bit in this new rate-hike cycle until Trump’s surprise win convinced currency traders the Fed would have to start hiking faster. And the dollar picture before that US-election surprise was considerably more bearish than that.
Back in mid-2014 the USDX started skyrocketing in an epic rally on mounting expectations of Fed rate hikes coming. Remember the Bernanke Fed had forced rates to zero, or technically a target range from zero to 25 basis points, back in mid-December 2008. That’s where they lingered for exactly seven years until mid-December 2015. Provocatively the USDX didn’t collapse during that zero-interest-rate-policy era.
If higher US interest rates are bullish for the dollar, doesn’t the corollary imply lower interest rates are bearish for the dollar? Yet while US rates were first bludgeoned down to and then held underwater at record lows by blatant Fed manipulations, the USDX simply ground sideways on balance for years on end despite ZIRP. If ZIRP wasn’t bearish for the dollar, why should normalizing rates be exceptionally bullish?
But as the Fed increasingly hinted about ending ZIRP back in mid-2014, currency traders flooded into the US dollar and drove a monster rally in anticipation of Fed rate hikes coming. The USDX skyrocketed an incredible 25.6% higher in just 8.4 months, its second biggest and fastest rally in history! All of this frenzied dollar buying finally climaxed in March 2015 in extreme euphoria, as I warned about at the time.
If you weren’t closely watching the dollar then, the euphoria was just breathtaking. It eclipsed today’s in many ways, with traders universally convinced the USDX was due to soar much higher in the years to come. Yet with all the potential buyers already sucked in by the extreme greed, that proved the very top. Over the next 1.7 years leading into 2016’s Election Day, the USDX actually defied sentiment to drift 2.3% lower.
So without that extreme post-election surge on all the Trumphoria, the USDX has been drifting sideways for almost two years. That’s despite endless hawkish Fedspeak from elite FOMC officials implying more rate hikes are coming soon. The hawkish dot plot at the FOMC’s latest meeting was nothing new. This Yellen Fed has cried hawk so many times in recent years that its forecasts should have zero credibility.
The USDX’s epic rate-hike-anticipation surge was born in May 2014. The Fed’s dot plot in June 2014 showed expectations for four rate hikes in 2015 taking the federal-funds-rate up to a target between 100 and 125 basis points. Yet how many rate hikes did the FOMC actually execute over the next year and a half? A single one in December 2015! The dot plot is always far more hawkish than what the Fed actually does.
A year ago after the Fed’s first rate hike in 9.5 years in mid-December 2015, the USDX surged because the accompanying dot plot forecast four rates hikes in 2016. But once again after talking tough, all the timid Yellen Fed could actually muster in 2016 was another single hike this December. Literally for years now, the FOMC has been forecasting far more rate hikes through its dot plot than ever come to pass.
So when the latest dot plot this month projected three rate hikes in 2017, up from two a quarter earlier, it is shocking currency traders still take the Fed seriously. What’s almost certain to happen again is the stock markets will suffer a material selloff sometime early next year. Nothing concerns the FOMC more than stock-market levels, as the Fed suffers withering criticism if it doesn’t act immediately to arrest major selloffs.
The Fed also constantly fears the negative wealth effect from falling stock markets will retard consumer spending and therefore weaken the entire US economy. So once the stock markets inevitably drop into 10%+ correction territory again in the coming months, this tough-talking hawkish Fed will lapse back into dovish mode so fast traders’ heads will spin. The US dollar will be lucky to see one rate hike again in 2017!
But let’s be as gullible as the constantly-Fed-fooled currency traders and assume three rates hikes are indeed coming in 2017. Surely that would indeed be very bullish for the US dollar, right? Let’s look to the last Fed-rate-hike cycle for clues. From June 2004 to June 2006 the FOMC hiked its federal-funds rate 17 consecutive times over 24.0 months for a massive 425 basis points total, more than quintupling the FFR!
If currency traders are right that Fed rate hikes are bullish, surely the US dollar rocketed heavenward as the federal-funds rate was relentlessly catapulted from 1.00% to 5.25%. That enormous increase in US yields must have made the dollar wildly more attractive for foreign investors. Yet what really happened? The USDX actually fell 3.8% over that exact Fed-rate-hike-cycle span! The reality doesn’t support the theory.
After that, the FOMC held the federal-funds rate at that lofty 5.25% level for another 14.7 months until late 2007, when the global financial crisis leading into late 2008’s stock panic started brewing. With an FFR so high that it would literally bankrupt the US government today, foreign capital should’ve deluged into the high-yielding US dollar. Yet during that very 5.25%-FFR span, the USDX actually slid 8.0% lower!
Clearly something is dreadfully wrong with the notion undergirding today’s USDX euphoria, that higher US interest rates fuel major dollar rallies. The opposite has actually proven true in the past! So currency traders who understand history make the argument that higher rates now are different in a low-yielding world. If the Fed pushes the FFR higher with the rest of the world yielding nothing, dollar buying will come.
The US dollar’s main world-reserve-currency competitor is of course the euro, which accounts for 57.6% of the USDX’s weight. Between June 2006 and September 2007 when the FFR target ran way up at 5.25%, the equivalent rate for the European Central Bank ran between 3.75% to 5.00%. That early 150bp positive yield differential between the dollar and euro dwarfed the 38bp today. But the dollar still fell!
The hard truth is the US dollar is wildly-overbought today, with extreme greed and euphoria rampant. At a lofty 14.0-year secular high thanks to the dazzling post-election Trumphoria rally, any dollar buying on more Fed rate hikes has already been pulled forward. Regardless of what the FOMC does, the red-hot USDX is overdue for a sharp decline as extreme long positions are unwound. That reversal is imminent.
Provocatively the US dollar has a history of running in 7-year cycles, 7-year bull markets are followed by 7-year bear markets. Between its July 2001 peak and April 2008 all-time low, the USDX dropped 41.0% over 6.8 years despite a massive Fed-rate-hike cycle. And from there up until that extreme March 2015 peak following that epic rate-hike-anticipation surge, the USDX powered 40.4% higher over 6.9 years.
That really should’ve been the end of the dollar’s bull run, as the sideways USDX action between then and the election strongly argued. The only thing that pushed the USDX higher still was the stunning post-election Trumphoria, which extended the USDX’s secular bull to a 44.7% gain over 8.7 years. That is far too long for a dollar bull market to last, greatly increasing the odds that a new bear market is looming.
The most-likely potential catalyst igniting serious dollar selling is the Fed going dovish. In early 2017 it’s highly likely these wildly-overvalued euphoric stock markets will roll over into a correction-grade selloff. That will terrify the FOMC, which will soon start talking dovish. Rate-hike expectations will crater, and the federal-funds rate will remain at today’s stock-panic levels just above ZIRP. Fierce dollar selling will ensue.
Interestingly the primary beneficiary of US-dollar weakness will be gold. Gold prices are dominated by gold-futures speculators and gold-ETF investors. The futures guys often base their collective trading decisions on the fortunes of the US dollar. They tend to aggressively sell gold futures when the USDX is surging, and aggressively buy gold when the dollar is falling. That’s readily evident in this gold-and-USDX chart.
Every major USDX move since its all-time low in early 2008 is noted here, with this chart divided at the resulting major USDX highs and lows. Note that gold has a strong negative correlation with the US dollar. That makes sense since gold has been the ultimate currency all throughout world history. The gold-futures speculators flee gold when the dollar strengthens and then return as the dollar weakens.
Along with the stunning post-election stock-market rally that sucked capital out of gold, the even-more-incredible post-election USDX rally is a major reason gold plunged 11.4% since Election Day. There is no doubt that once this blistering dollar surge reverses, gold futures will catch a serious bid again. Traders’ gold-futures selling has been so extreme since the election that they are now positioned to buy heavily.
Before Trump’s surprise win on election night, gold surged as high as $1337! It easily has the potential to return there in short order as this post-election dollar surge is inevitably unwound. Gold’s gains as this wildly-overbought US dollar reverses are likely to be inversely proportional. The bigger and faster the dollar’s overdue drop, the bigger and faster gold’s rebound rally will be. The likely igniting catalyst is ironic.
The Fed will once again start talking dovish and quickly ratchet down rate-hike expectations when the stock markets sell off materially. That will crush the rate-hike-expectation-driven dollar surge. But the lofty dollar itself is the thing most likely to spark that serious stock-market selloff! The dollar blasting to 14-year secular highs after the election is very bearish for the US corporate earnings undergirding stock markets.
Something like half the revenues of the elite S&P 500 companies come from abroad. The surging dollar makes the goods and services they are selling to foreigners more expensive in local terms, naturally retarding demand. On top of lower sales, any profits earned in foreign countries have to be translated back into dollar terms at very-unfavorable exchange rates. This slams corporate profits, spawning stock selloffs.
In Q4’15, the USDX climbed 2.4% on Fed-rate-hike expectations. This was a major factor helping force overall S&P 500 companies’ profits 6.0% lower year-over-year in that quarter. Gold dropped 4.9% during that span on major dollar euphoria. Yet in Q1’16 as the negative earnings impact of that strong dollar came home to roost, the USDX fell hard with a 4.0% loss while gold rocketed 16.1% higher in a major new bull.
Quarter-to-date in this year’s Q4, the USDX has rocketed an astounding 7.8% higher! That contributed big to the brutal 14.2% QTD gold plunge, one of gold’s worst quarters in history. After such an extreme quarterly rally, the USDX is likely to reverse hard and fall proportionally in Q1’17. That gives gold a high probability of seeing Q1’17 gains in line with Q1’16’s big ones, and symmetrical with this quarter’s big losses.
So the anomalously-strong US dollar itself is likely to blast corporate profits so seriously in the imminent Q4 earnings season that it unleashes the overdue major stock-market selloff. That will once again get the cowardly FOMC to shift on a dime from hawkish to dovish. And the resulting major reversal of the excessive US-dollar long positions in this wildly-overcrowded trade will cause it to plunge. Thus gold will surge.
There are a couple ways to play this coming sharp US-dollar selloff. Stock traders can short or buy put options on the US Dollar Index ETFs including the leading UUP PowerShares DB US Dollar Index Bullish Fund. They can also buy outright or buy call options on the mighty GLD SPDR Gold Shares gold ETF that dominates its peers. Being short the euphoric dollar and long gold should prove one of early 2017’s best trades!
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The bottom line is the US dollar’s post-election surge to major secular highs has spawned truly extreme euphoria. Traders have aggressively crowded into this popular long-dollar trade, totally convinced Fed rate hikes will drive the dollar much higher. Yet recent history showed the opposite, that the dollar didn’t rally during either Fed-rate-hike cycles or the resulting peak rates before the FOMC reverted to cutting again.
As soon as these lofty stock markets inevitably roll over again, the hawkish Fed will quickly turn dovish just like in recent years. And the red-hot US dollar will plunge as traders rush to unwind their excessive dollar longs. The dollar’s sharp reversal lower will ignite massive buying in gold futures, propelling this beleaguered metal sharply higher. Extreme dollar greed never lasts, and warns of a major topping underway.
Adam Hamilton, CPA
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