Why it’s Time to Side with the U.S. Dollar

A debt downgrade from Standard & Poor’s is just more bad news on top of more bad news for Brazil.

The country is faring worse than most emerging markets in this very unfriendly economic environment.

That’s saying something, because many currencies have made huge moves … most of them in the same direction (down).

Currencies

Since June 2014:

  • The Brazilian real is down 43%.
  • The Mexican peso is down 23%.
  • The Australian dollar is down 24%.
  • The Russian ruble is down 50%.
  • The Malaysian ringgit is down 27%.
  • The Korean won is down 14%.

The euro is down 17%, but European Central Bank Chief Mario Draghi just pledged to stay accommodative with monetary policy.

In the chart above, you’ll see there’s one currency that’s gone higher. The U.S. Dollar Index is up 19% and the Federal Reserve is about to hike its benchmark interest rate and presumably prop up the U.S. dollar even more.

Everyone and their stuffed panda bears know China has been struggling to keep the renminbi steady. Last month’s sudden depreciation sounded the currency war chants.

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China’s premier Li Keqiang threw his arms up in the air in innocence saying "China will never resort to a currency war."

Yeah, Mr. Li, we know.

How do we know?

We know because a currency war among nations is about as real as an integrity war among politicians.

Hillary Trump Jeb

Let me put on my aluminum foil hat for a moment and say a currency war is merely a politically charged meme used to distract the layperson from the maniacal aims of "coordinated monetary policy."

The idea of currency war, out of necessity, must pit one side against another.

Except that currencies are not some weapon to destroy a foe.

Currencies are more like battlefield triage — they’ll tell you the temperature and reduce to effects of global policy aggression, market pressures and economic trauma.

You see, currencies, in a floating exchange-rate system, act as pressure valves. Exchange rates ebb and flow based on relative value — market expectations for one nation’s economy vs. another’s.

Capital is always flowing in or out, for one reason or another.

Today’s ebb and flow just happens to feel more extreme than usual. Chalk that up to the boom-and-bust manipulation of extraordinary monetary policy.

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Assume that Korean exports of intermediate goods stall, the manufacturing sector contracts and consumers rein in spending.

Also assume Japanese exports of finished goods pick up speed, the manufacturing sector blooms and consumers feel good enough about it to increase expenditures.

The Korean won is likely going to depreciate in value vs. the Japanese yen as investors seek to reduce their exposure to a fledgling economy while increasing their exposure to an economy with growth potential.

Straightforward enough?

Good.

So that happens — the Korean won slumps while the Japanese yen strengthens. As these values change, so too does the dynamic that drove the values of these currencies in the first place.

A weaker Korean won means Korea’s exports have become cheaper. A stronger Japanese yen means Japan’s exports have become costlier.

Expectations change and imbalances balance.

Except when they don’t.

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When Brazil’s credit rating was cut to junk last week, its currency fell 2.9% vs. the U.S. dollar. That’s a big move.

The currency has lost so much value — more than 30% this year alone — that inflation is running higher than Brazil has seen it in 12 years.

Brazil’s central bank is responding with rate hikes, hoping its currency will stop dropping. But its efforts have proven futile on the currency front and counterproductive to growth.

Brazil’s economy has suffered from a miserable commodity market and falling exports, namely to China.

Brazil is a casualty of war right now. But not of a currency war …

Normally, a depreciating real would help make Brazil’s exports more competitive and help support manufacturing. But the financialization of commodities, if you will, stemming from easy money — a growth-at-all-costs mentality of global policymakers — has generated global excesses and imbalances that require a significant and painful unwind that a currency cannot quickly remedy.

The credit crunch applied pressure on the Western banking system.

The commodity crunch is applying pressure on emerging markets’ growth model.

Both crunches are the result of policymakers battling to manipulate economic cycles. Currency fluctuations are merely symptoms of a defunct system trying to right itself.

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Maybe I’m just calling a tomato a tomato here.

So let me cut to the chase: It’s time you side with the U.S. dollar.

I feel like I should smack myself in the face when I say the U.S. economy will prove more healthy and stable over the coming months and quarters than most any other meaningful economy.

American growth will withstand a Federal Reserve interest rate hike.

It will withstand a stronger U.S. dollar, since manufacturing is a relatively small portion of the U.S. economy. Though workforce participation and wage growth is pathetic, payrolls are rising and productivity is increasing.

The U.S. remains the center of global credit. During crises, money always flows back to the center.

Globe

There will eventually be opportunities to buy into currencies and economies that have been beaten down. Brazil and Russia are significant players, but they’re not places to park your money just now.

If I’m right, and the Federal Reserve is resolved to begin a rate-hike campaign, then central bank policy divergence will remain a key rationale for U.S. dollar strength.

The easiest way to play it is through purchasing shares of the PowerShares DB U.S. Dollar Index Trust (UUP).

Based on my pattern analysis, the U.S. dollar may undergo a month or so of weakness before another significant rally.

Dollar Index

So it might make sense to take a small position now and look to add on either a pullback toward 92 on the Dollar Index or a breakout above 98.

Do right,

JR Crooks

“JR” specializes in trading commodities, currencies and options. He has spent nearly 10 years analyzing financial markets and writing about global economics. JR honed his trading techniques and global-macro worldview alongside his father, Jack Crooks, at Black Swan Capital. JR also…