The U.S. Dollar Just Had its Worst Month in a Decade

By John Banks

In the month of June, we sent a report to TradeSmith Decoder subscribers titled “The Best Time to Buy Gold Stocks in 90 Years.” The report emphasized the precious metals stocks we liked best — many of which were purchased for the TradeSmith Decoder model portfolio — and noted the likelihood of accelerated currency decline.

In the following month, July 2020, the U.S. dollar saw its worst single month in a decade, according to the Financial Times.

The trade weighted U.S. dollar index — a measure tracked by the St. Louis Federal Reserve — has also definitively broken below its 10-year trendline support.

In addition to gold, the diving dollar has been wonderful for Bitcoin, silver, copper, and precious metals stocks — areas where TradeSmith Decoder’s largest positions are concentrated.

Beyond that, the profoundly weak dollar has also been good for stocks overall, which leads to a question: How much of the market going “up” can actually be attributed to the dollar going “down”? 

Because U.S. assets are quoted in dollars, and all major commodities are typically quoted in dollars, and the bulk of international trade is conducted in, and financed by, dollars — even for transactions that don’t involve the United States — the dollar is a de facto yardstick for the world’s prices.

But this yardstick is made of rubber, or perhaps silly putty. The metaphorical length of the yardstick, meaning the U.S. dollar’s worth, can expand or contract, sometimes wildly. Those fluctuations, which are sometimes extreme, impact the perceived cheapness or expensiveness of items priced in dollars.

When the dollar declines in value, commodity prices tend to rise, again because the latter is priced in the former. This is common sense when you think about it. If a pile of dollars is worth less than it was the day before, it will generally take a larger pile, with more dollars in it, to buy 25,000 pounds of copper or 5,000 bushels of soybeans.

A weaker dollar is also good for U.S. multinational companies, in that it makes their overseas profits look bigger. When, say, the euro rises to a two-year high against the dollar (as happened recently), a multinational company that earns a portion of its revenue in euros will see a bigger profit, in U.S. dollar terms, when it calculates a currency conversion and reports its quarterly earnings in dollars.

Then, too, a weaker dollar makes it easier for other countries to buy dollar-priced goods. If the euro and the yen are strong in comparison to the dollar, E.U. citizens and Japanese citizens will perceive American goods as being less expensive, and import more of them (assuming no trade barrier).

On the whole, a weak currency is a good thing for a country’s exporters, for the reasons described above. This is why a great many countries prefer a weak currency to a strong one, and why “currency wars” involve repeated attempts to weaken the home currency, not strengthen it (a weaker currency is more competitive in export terms).

A weak currency can also be good for a country’s stock market, to the extent that currency debasement fuels not just commodity and raw materials inflation, but asset price inflation. When investors and consumers get it fixed in their heads that “cash is trash,” they become more willing to shovel their excess cash into anything that isn’t cash — which can then provide a lift to asset categories like retail stocks, high-yield debt, or real estate.

For those who know what they are doing, an inflationary episode driven by currency debasement — where general deflationary trends are juxtaposed against pockets of asset-price inflation — can be an opportunity to earn a fortune. This hasn’t just been true all through the 20th century, it was true in the middle ages (as we’ll explore in another episode).

And yet, for all that, if a currency grows too weak, there are serious downsides.

The biggest danger is the possibility of a self-reinforcing negative feedback loop: As the currency loses purchasing power, holders of the currency decide to sell at the margins, swapping a portion of their currency for something else. As the currency experiences more selling pressure, its value then erodes further, intensifying the desire of holders to be shed of it.

If this feedback loop progresses far enough, you wind up with societally destructive inflation via rapid currency decline, or a currency crisis born of too many currency holders trying to exit at once, or both at the same time.

Crises like these also tend to rip society apart, to the extent that the skilled and well-connected can navigate the dangers of currency depreciation to a place of safety, or large profits, whereas the average saver, having put their savings in the wrong place, sees what little they’ve accumulated go up in flames. 

A currency that declines too much or too rapidly can also present major problems for underlying private and public debt markets.

If a country borrows in a currency other than its own, foreign-denominated debt service costs can become crushingly expensive as the value of the home currency falls. This is what drove the Asian currency crisis in the late 1990s (too much leverage in a non-local currency).

Countries with a higher degree of sovereignty, like the United States, do not have to borrow in someone else’s currency. For the most part the U.S. can borrow in dollars, and also create new dollars, which is a distinct and powerful advantage. There will never be a need for the U.S. to officially default on a dollar-denominated debt, because the Federal Reserve can simply swap the debt for new dollars in order to pay it off.

A dangerous feedback loop still exists, though, even for countries like the United States. That is because, if the Federal Reserve decides to retire debt with dollars, it has to add more dollars to the system in order to do so.

To put it another way, the U.S. Congress could, if it so chose, decide to authorize $10 trillion worth of spending, and the U.S. Treasury could issue $10 trillion worth of new U.S. debt securities, and if nobody wanted to buy this debt the Fed could just buy it, adding $10 trillion to the Federal Reserve balance sheet.

In our hypothetical example, everything would be fine except for one problem — to purchase the $10 trillion of new debt, the Fed would have to unleash $10 trillion in new dollars upon the world, greatly expanding the available currency supply.

That, in turn, would increase the likelihood of price inflation through currency debasement — all of the “stuff” that is priced in dollars becoming more expensive as the dollar supply expands — and would also create a sense of urgency among dollar holders in regard to trading their dollars for something else.

What this means is that nobody gets a free lunch, not even the Federal Reserve. A country with monetary sovereignty can always swap debt for currency, but if the currency supply grows too large, the country runs the risk of runaway inflation tendencies and investor capital flight.

A modest version of this is what the U.S. dollar is experiencing now, we would argue. The threat of a greatly expanded currency supply, and a reduced desire to hold U.S.-dollar-denominated debts, helps explain why the world has been moving away from the dollar.

Then, too, the Federal Reserve has made it perfectly clear the dollar will receive no help. Not only that, the Fed is willing to trash the dollar, if need be, in order to keep the struggling U.S. economy propped up.

“The Federal Reserve is preparing to effectively abandon its strategy of pre-emptively lifting interest rates to head off higher inflation,” the Wall Street Journal reported on Aug. 2, “a practice it has followed for more than three decades.”

In plain English, that means the central bank won’t do anything to strengthen the dollar (like raise interest rates) in the presence of rising prices or investor-capital flight. The priority of low interest rates (again to prop up a weak economy) will instead take precedence.

The world sees and understands this plan, and it is getting shed of dollars.

And because the world has historically been overweight U.S. dollars for a very long time — with dollar-denominated assets making up 60% or more of central bank reserve assets — there are plenty of them to be shed of.

This, in turn, means the U.S. dollar could experience a great deal of selling, over an extended period of time, simply to get the average dollar-denominated asset weighting more toward “normal” levels in a portfolio, e.g. 40% instead of 60% (which would still be more than double the size of the U.S. economy as a percentage of global GDP). 

The upshot here, for reasons we’ll explore in future episodes, is that the U.S. dollar’s decline likely has much further to go. It’s not every day you see a currency break 10-year trendline support, much less at the tail end of a 40-year long-term debt cycle, from a position of mass overweighting in global portfolios.

And as you might expect, all of this is very good news — not just in the medium term, but the longer term, stretching out for years — for “anti-dollar” assets like gold, silver, precious metals stocks, and Bitcoin.