Why I Sell The Dollar: From Dollar Strength to Dollar Weakness

By: Axel G. Merk, Merk Investments / GoldSeek.com

Q3 of 2013 marked a peak and reversal of direction for the dollar. The notable strength in the dollar during Q2 turned into an equally prominent weakness in Q3 compared to a basket of foreign currencies. All of the G10 currencies strengthened against the dollar during Q3, while the price of gold rose more than 7%. See attached chart for the performance of the U.S. Dollar Index for the year through 10/31/2013.

Euro, the Undiscovered Rock Star

In our outlook at the beginning of this year we predicted the euro might become the Rock Star of 2013. When the currency pulled back in the spring, we clarified it might be a rocky ride to stardom (see our analysis “Chaos Investing Unplugged”). By October, the euro gradually climbed back and topped 1.38 in October. While there is still a widespread perception that the common currency of Europe is fairing poorly, in reality the euro was the best performing G10 currency as of this writing, year to date versus the dollar. Why do people believe the euro is going down? We think it may have to do with the misconception that economic recovery and currency performance necessarily go hand in hand. In our analysis, however, not all currencies are created equal.

To illustrate the point, consider the yen: the more dysfunctional the Japanese government was (a dysfunctional government is unable to spend money or exert pressure on the central bank), the stronger the yen appeared to be despite the lack of economic growth. In fact, the yen soared higher in early 2011 when the earthquake caused the devastation in Fukushima; a few weeks later, Christchurch in New Zealand was hit by an earthquake, causing the kiwi (New Zealand dollar) to fall. A shock to each economy, causing consumers in the immediate aftermath to spend less and save more. The reason we believe everything appeared to work “backwards” in Japan was because of the country’s current account surplus: as the country was not dependent on foreigners to finance its budget deficit, the expected urge to save by the Japanese exerted upward pressure on the currency. In contrast, the kiwi suffered as foreigners might be less inclined to invest in the country in the immediate aftermath of the earthquake. This is an oversimplification, but is meant to illustrate the point that currencies react differently in different countries to certain economic indicators. The Eurozone, on that note, has a small current account surplus; as a result, we believe, the euro can thrive even in the absence of economic growth.

Differently put, other factors such as prevailing monetary policy may have a much stronger impact on currency moves. Alas, while the European recovery is painfully slow, it relies more on structural reforms and less on accommodative monetary policy. Specifically, the euro has benefitted from a shrinking European Central Bank (ECB) balance sheet from early Long Term Refinancing Operations (LTRO) repayments as well as subsiding fears about negative deposit rates hinted at by the ECB earlier in the year. While the ECB just recently and unexpectedly cut its policy rate over disinflation concerns, in our assessment, the ECB has less flexibility than other central banks, particularly the Fed, in implementing policies that would weaken the currency.

The most powerful driver behind the euro may be that it is attracting risk-friendly capital, yet did not participate in the rally of recent years that pushed other so-called risk-friendly assets (such as U.S. stocks to name just one) to the stratosphere. This may sound technical, but consider that many that sold emerging market local debt securities are now buying fixed income instruments issued by peripheral (weaker) Eurozone countries. The previous generation of investors that mistakenly thought peripheral Eurozone securities were safe have fled; the new generation is willing and able to take on the risks associated with the securities. We are not suggesting that those securities are suddenly safe, but the risk of “contagion” is dramatically reduced as risk-friendly investors allow risk to be priced locally; in contrast, when an institution deemed too big to fail has significant exposure to risky assets, the fear of contagion can cripple the entire region. As proof, look at Cyprus: during the peak of the crisis, Spain had a Treasury auction where the country paid the lowest yield since the early 1990s. The market is letting us know that a crisis in the Eurozone is not the same as a crisis in the euro.

In summary, we believe the euro can be strong, while the European economy is still relatively weak.

Dollar, Out of the Frying Pan, Into the Fire

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