by David Stanowski
10 November 2010
"Everyone knows that the Dollar will soon become worthless, because the FED is going to run the printing presses!"
The first problem with what "everyone knows" is that the FED is NOT printing money, it is creating credit; two very different processes. In addition, what "everyone knows" about the financial markets is usually of little or no value!
In fact, there is actually compelling evidence that the Dollar is likely to increase in value over the next several months! Investments that do well while the Dollar is falling, will probably lose money when the Dollar strengthens, so understanding the likely path for the Dollar should be a critical part of all financial decisions.
Since 1913, the year that the FED was created, the Dollar has lost 93% of its value, i.e. purchasing power, as measured by the All Commodities PPI! Therefore, history shows that there is every reason to believe that the value of the Dollar will continue its march towards zero, as long as we continue to utilize a fiat money system, but that does not preclude long periods of countertrend moves that may carry the Dollar much higher than most people can imagine! In addition, purchasing power is only one way to measure the strength of the Dollar.
The Dollar trades against all of the other currencies in the world. Like the Dollar, these currencies are managed by their central banks, and they are also inflating away their values, but at differing rates. Therefore, even though the value of the Dollar is in a long-term downtrend, at times, it may be falling at a lower rate than the value of other currencies. In other words, when measured against other currencies, the value of the Dollar is "relative".
The Dollar can be bought or sold against any one currency, or against a basket of currencies. Since 1973, the U.S. Dollar Index has served as the benchmark for the Dollar's strength against the other major world currencies. The weighting in the Index is: Euro 57.6%, Japanese Yen 13.6%, British Pound 11.9%, Canadian Dollar 9.1%, Swedish Krona 4.2% and Swiss Franc 3.6%.
The following 25-year chart of the U.S. Dollar Index shows the price action from November 1985 to November 2010. This graph displays a sideways pattern, or trading range, with a downward bias, rather than the "collapse" that is so often described.
During this period, the Dollar Index peaked at 122.15 in January 2002, and then bottomed at 72.08 in July 2008; a loss of 41%. This steep 77-month decline is what created the consensus for a continuing and accelerating decline leading to the "destruction of the Dollar". What is overlooked, to draw this conclusion, is the fact that, even in the face of the stock market decline of 2007-2009, the actions of the FED since 2007, and all the current hysteria over the certainty of the impending Dollar collapse; the Dollar has held ABOVE its July 2008 low!
To Contrarians, a very important part of market analysis is the sentiment of investors and traders. When investors get overly bullish, prices are nearing a top; and when investors get overly bearish, prices are nearing a bottom. One of the most well-respected measures of sentiment is the Daily Sentiment Index (DSI). A DSI greater than or equal to 90% bulls is considered overly bullish, and a DSI less than or equal to 10% bulls is considered overly bearish.
Notice how a DSI of 6% bulls in early 2008 set up a 25% rally in the Dollar Index, but that rally eventually lead to a DSI of 93% bulls in early 2009 which set up the necessary conditions for a decline of 18%. Next, the low in the Fall of 2009 lead to the very extreme reading of only 3% bulls which reflected a pervasive bearishness that set up another rally of 20% in the Dollar Index that culminated in a DSI reading of 98% bulls in the summer of 2010. Extreme DSI readings continued to accurately predict trend changes as the current decline began with a DSI reading of 98% bulls. The Dollar Index has now dropped 16% below its summer 2010 high, so far.
Looking at the sideways move in the Dollar Index, since mid-2008, combined with the DSI readings, it should be clear that the current decline, that has lead to the recent surge in negative sentiment towards the Dollar, is most likely in the process of ending!
The activities of the federal government and the FED that give many people reasons to believe in a Dollar collapse, have been occurring for almost three years, and yet the Dollar has held above its low of July 2008, as negative sentiment has set the stage for another strong Dollar rally.
Supply and Demand:
The primary reason that "everyone knows" the Dollar will collapse is the belief that if the FED creates Trillions of new Dollars (with new credit; not by printing money) the added supply will make the value of each Dollar decline. This is true, but what if existing Dollars are being destroyed faster than the FED is creating new Dollars? Then the total number of Dollars will actually shrink, and the value of each Dollar will increase.
It is much like adding water to a bucket. After the water level nears the top of the bucket, if more water is added, it seems certain that the bucket will over flow. It is certain unless a hole is punched in the bottom of the bucket. Then, it cannot overflow unless the rate that water is added to the bucket exceeds the rate at which it is draining out.
In today's economy, with many measurements hidden from view, these calculations are difficult to perform with any accuracy. It is difficult even for those who know that there is a hole in the bucket, but impossible for those who do not!
The water going into the bucket is the new credit that the FED is creating. The water draining out of the bucket is the destruction of existing credit such as those home owners who owe more on their houses than they are now worth. The amount of credit has declined as the value of those mortgages are now worth less than face value. Most attempts to measure the net result between the inflow and outflow of credit show a net loss of total credit; i.e the conditions necessary to allow the Dollar to gain in value.
The following graph shows one measure of consumer credit contracting for the first time in over 50 years!
As expected, the rate of change of this same data series is now strongly negative.
This is an example of water draining out of the hole in the bottom of the bucket faster than it can be added to the bucket; i.e. the destruction of credit and the reduction in the number of Dollars in the economy.
Inflation and Deflation:
Everyone has learned to live and invest in an inflationary environment. Now that the government has ramped up its bailouts and stimulus plans, and has announced plans for QE2, many are preparing for the hyperinflation that may or may not materialize at some point in the future. What most people fail to recognize is that we have entered a deflationary period. This trend could have a long way to go, and the failure to adjust to these new conditions could lead to financial ruin!
Most people focus only on prices when they try to gage inflation and deflation, but it's not that simple, because prices respond to supply and demand as well as inflation and deflation, so they are only one indicator.
Properly defined, inflation is "increasing money supply and credit, with credit marked-to-the market", and deflation is "decreasing money supply and credit, with credit marked-to-the market".
Using this definition, it is clear that a deflationary trend began with the top of the housing bubble, and subsequent contraction in mortgage debt and equity withdrawal, in 2005; grew stronger with the top in the stock market, and the more general contraction of bank credit, in 2007; and accelerated with the collapse of the investment banks in 2008, which forced the liquidation of a lot of the new "securitized" debt instruments.
Regardless of the current rallies in some markets, consumer debt continues to contract (see chart 3 above), the real estate market has been unable to find a bottom which forces a continued contraction in the associated debt, unemployment is shrinking the workforce and curtailing pay increases, and other bank credit and exotic debt instruments continue to lose value; so more deflation appears to be in our future!
During a deflationary period, most assets fall in price, and nearly all fixed-price long-term financial commitments, like mortgages, commercial property loans, and long-term commercial leases work against you, because they do not automatically adjust to an environment of lower incomes and cash flows.
It is much better not to invest in assets of this sort. During a deflationary period, CASH is KING, and short-term flexible commitments work best. Most people are forced to sell assets, often at very low prices, to raise the cash to make this transition, but it works much better if you get out ahead of it and sell before you are forced to.
Switching from an inflationary environment to a deflationary environment has literally turned the world upside down. Many people have discovered this the hard way, and millions more will soon! It's time to learn the rules that govern a deflationary environment.
How to Survive Deflation
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