The Dollar Breakdown: A Sign of Inflation to Come?

By Mishka vom Dorp



 

Recently, we saw the dollar index (the DXY), which measures the USD against a basket of the world’s major currencies, break below its support of 91 for the first time since January of 2015 (Figure 1). This event may signal the most important trend of 2018: the breakdown of the dollar.

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Figure 1: Daily Dollar Index (DXY)  Source: Thomson Reuters Eikon


The recent drop of .96 percent was the second largest drop in over a year and caught many traders by surprise given the recent strong U.S. retail sales data which increased their expectations of a rate hike in March to 75 percent.   Some of this selloff can be attributed to the strengthening Euro that came after the German Chancellor, Angela Merkel, announced an agreement to form a coalition government.

This deal had been struck after months of negotiations while the weakening dollar has been a year-long trend. Shortly after President Trump was elected in November of 2016, we saw the dollar rally over 5.5 percent only to hit a peak of over 103 in December of that year.  

In December of 2016, I wrote that a strong dollar would be the biggest headwind against the Trump administration’s domestic economic policy agenda: 

“If Donald Trump plans on bringing manufacturing jobs back to the United States, the dollar will be his main enemy. Since Trump’s election victory, the central bank's dollar gauge has risen over 4 percent against a basket of major currencies (Figure 2):

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Figure 2: Broad Index of the Foreign Exchange Value of the Dollar      Source: Bloomberg


This should worry the President-elect since exports and manufacturing jobs will remain uncompetitive as long as the dollar continues to strengthen. Sure, he can place disruptions in the market such as tariffs to make foreign goods less competitive, but that would start an international trade war which would be a zero-sum game. Instead, the President-elect, once sworn in, can manufacture competitiveness through fiscal policy. With Trump’s planned tax cuts coupled with his planned infrastructure spending … the fiscal policy measures once implemented will be highly inflationary which should be good for gold [and bad for the dollar].” —Is it Time to Catch a Falling Knife? Dec. 15, 2016.

Furthermore, a strong dollar would likely exacerbate the U.S. balance of trade deficit by making foreign goods cheaper. Both things Trump has stated multiple times he is looking to fix and he himself acknowledged the best way to do this is by having a weaker dollar. 

I also wrote about Fed Chairman Janet Yellen who, with her recent hawkish shift, is seen as the biggest roadblock for the Trump Administration and its wish to manufacture a week dollar if the Fed continued to raise rates:

“Janet Yellen, the Chair of the Board of Governors of the Federal Reserve, has her term ending on February 3rd, 2018. The Fed’s main mandate is to keep inflation rates at 2 percent. With an inflationary fiscal policy regime implemented by Trump, Janet Yellen could be the only person to stand in Trump’s way. That is why Trump will most likely not  reappoint Yellen, and instead appoint someone who would be more amenable to keeping rates low. Furthermore, there are two vacancies on the board and they will most likely be dovish replacements.“ —Is it Time to Catch a Falling Knife? Dec. 15, 2016.

So it did not come as a surprise when Trump announced he would be replacing Yellen with Jerome Powell as his choice to lead the Fed in November of last year.

With Powell set to take over in February, it is likely he will take an even less aggressive approach to raising rates than that of Yellen. Either way, the weaker dollar has helped sustain gold’s buoyancy despite the five rate hikes we have seen since 2015 (Figure 3).

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Figure 3: Gold (yellow) vs DXY (purple)   Source: Thomson Reuters Eikon


Looking back over the past year, one can see there is a strong inverse relationship between gold and the dollar which has only strengthened over the past month. I believe the recent slide below support levels opens the door to a rally that could be similar to what we saw in the early 2000s, when the DXY broke down from 120 and fell all the way to the low 70s in 2008 (Figure 4).


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Figure 4: Gold (yellow) vs DXY (purple)   Source: Thomson Reuters Eikon


So where does gold go from here?

There are two major factors which I believe influence gold. The aforementioned dollar and real interest rates, which is the nominal rate set by the Fed minus inflation. A weaker dollar obviously means a stronger gold price in dollar terms but the real rate’s influence is a bit more convoluted. Since both Treasurys and gold are seen as safe-haven assets, investors who are worried about market risk have a choice to park their savings in a “risk free” asset that has a yield (Treasurys) or one that does not (gold). If real rates are positive, investors will likely favor Treasurys, since they provide a yield above that of inflation. However, when the inflation rate is greater than or equal to the nominal rate, investors prefer gold, since parking cash in Treasurys yields a negative return.

However, despite the Fed's efforts to manufacture inflation through historically low interest rates and large-scale asset purchase programs, we still have yet to see the Consumer Price Index (CPI) rise significantly, hence real rates have remained in positive territory. The best way to view real rates is by looking at the yields of Treasury Inflation Protection Securities (TIPS), where the principal is adjusted up and down based on CPI data. Looking at the 10-Year TIP (Figure 5), one can see the inverse relationship of TIPS to gold.


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Figure 5: 10-Year TIPS (orange) vs US Gold Spot Price (yellow)      Source: Thomson Reuters Eikon


What arguably sparked the end of the 5-year bear market in gold was the fall of the TIPS yield from 0.7 percent in January 2016 to negative real interest rates by July 2016. Since then, the 10-Year TIPS yield has bounced off the bottom to .53 percent.

With the recent decline in the dollar, from a U.S. consumer’s perspective, foreign goods and services will now cost more than they did a year ago considering the dollar has declined over 12 percent. With over 27 percent  of the of the U.S. GDP made up of imported goods and services, the effects will be felt far and wide. Though inflation takes time, there is a very good chance we could see real interest rates begin to decline over the coming year.

Though it is likely the Fed will attempt to counteract inflation by raising rates, it’s anticipated that President Trump will stack the deck with more dovish board members with the three current vacancies of seven total positions. From 1945 to 2001, the average economic expansion following a recession in the U.S. was just 
shy of five years. We are now into the ninth year of expansion and it is likely the Fed will have very little room to adjust rates down without going into negative territory once the next recession hits.


For now, I believe we will continue to see a weaker dollar, more inflation and a less aggressive Fed. This combined should all be positive for gold and the miners that extract the yellow metal.  The bull market which started in 2016 is now once again in full swing after a lackluster 2017. For those investors sitting on large cash positions, I believe now is the time to consider deploying funds into quality explorers, developers and producers. 

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