Falling oil prices might have been last year’s big story. But 2015 is all about the greenback.
After all, the U.S. dollar’s reach is bigger than just the commodity markets. (But we will look at its impact on gold and oil in just a few moments.)
The thing is, you can’t talk about global growth, inflation, interest rates or corporate earnings without taking the buck into account.
And with the U.S. Dollar Index up 25% since last summer, we have about 9 trillion reasons why the “almighty dollar” affects everything we do … and how we invest.
Since 2009, roughly $9 trillion in dollar-denominated debt has been issued in foreign branches of U.S. banks or in foreign banks.
With a dollar that is worth about 25% more, those loans and interest rates have also increased by 25%.
Think about this …
A $1 million loan at 10% has increased to about $1.25 million. And the interest rate has essentially increased to about 12.5%.
These loans have to be paid back in full. But if slow economic growth around the world would result in a global recession, we could see a rise in defaults.
After all, other currencies haven’t risen in tandem with the dollar. Nor has the dollar increased 25% against these currencies.
The dollar has risen relative to most of them.
The U.S. Dollar Index reflects the dollar’s exchange value against a basket of our trading partners’ currencies — the euro, British pound, Canadian dollar, Mexican peso, Chinese yuan, Australian dollar and others.
It’s important to note that the dollar has appreciated against some currencies more than others.
For example, according to the map above, the greenback is up 31% against the euro, but down 0.08% against the Chinese yuan.
Why the Greenback Has Gained
The dollar has rallied more than 40% off its low of 70 made in 2008.
The greenback was range-bound between 2008 and 2014. The rally picked up speed last December.
It consolidated the move in February before accelerating again.
Take a look at the PowerShares DB U.S. Dollar Bullish ETF (UUP):
There are plenty of reasons for the dollar’s rise: QE ending, stronger economic growth and speculation about rising interest rates.
On top of that, we are attracting foreign capital because of better economic growth than many other countries. This adds to the safety and liquidity of the dollar.
However, there is one other factor.
As we saw when oil was falling, it looks like the futures market is driving prices.
Only in the greenback’s case, it appears to be driving them higher.
Big Bets on the Buck
Keep in mind that the $9 trillion in dollar-denominated debt is held by borrowers outside the United States.
Dollar-denominated deposits at banks outside the U.S. are known as Eurodollars. That’s because many are held in Europe, where they are generally free of regulation.
Below is a table from Barron’s that shows the activity of the Eurodollar futures market.
The Eurodollar saw the most contracts traded during the last week of March, compared to gold and oil.
I’ve circled where large speculators were long 1.7 million contracts. At the same time, small traderswere short nearly 1.3 million.
But that’s not where the biggest action is.
Before we get to it, keep in mind that the futures market has a couple of key functions:
• To shift the risk from producers to risk-takers
• To set asset prices for buyers and sellers
If you look at the above table, most of the contracts belong to commercial hedgers, as they try to reduce their price and currency risk.
Here, we can see 6 million long and 6 million short contracts.
How Much Higher Could the Dollar Go?
Here’s a quick lesson on dollar futures. If the price of the U.S. Dollar Index is at 100, then the futures contract is worth about $100,000.
The Dollar Index traded at 98.7 yesterday. So that would put it at roughly $98,700. (Simply multiply $1,000 times the index value.)
The margin requirement is only about $1,950. So, this tremendous leverage attracts speculators.
Large speculators, deemed as the “smart money,” have more long contracts. Also long contracts have increased, and the shorts decreased.
Speculators and traders dominate the rest of the futures markets due to significant leverage in that area.
So, these aren’t investors driving the prices. Rather, traders are taking advantage of the large leverage that the futures market offers.
On the charts, there is overhead resistance at 100.
If the dollar can break above it, we could see it rally to 105. This would match its highs in the 1990s.
It’s possible that speculators could drive the dollar above 105, but my research tells me that the dollar would be overvalued if this happens.
The Benefits of a Strong U.S. Dollar
A strong dollar is a good thing for consumers as it makes foreign goods and services cheaper.
For example, if you want to take a vacation to Europe, now might be a good time. That’s because it’s about 30% cheaper to do now than it was in 2013.
However, you probably don’t have to rush to book that trip.
That’s because domestic producers and service providers will have to keep prices lower to compete against cheaper foreign goods and services.
This should keep a lid on U.S. inflation and, therefore, interest rates.
In fact, studying the Fed’s every word isn’t the only way to determine its direction on raising interest rates.
In their last news conference, Federal Open Market Committee members said they would be cautious about raising rates.
They understand the potential disruptions the strong dollar could have on the global economy, including dollar-denominated loans.
Why a Strong Buck is Bad for Blue-Chips
However, a strong dollar can be bad news for U.S. blue-chips that do big business overseas.
After all, foreign buyers will need more of their home currency to buy U.S. goods and services.
The stronger dollar and higher-priced U.S. goods and services should lead to weaker sales.
What’s more, U.S.-international companies face a currency conversion loss that happens when a weaker foreign currency sale needs to be converted into a stronger dollar.
With Q1 earnings season starting to pick up momentum, we will soon start to see the effects of the stronger dollar on U.S. multinationals.
What a Strong Dollar Does to Gold
Last but not least, a strong dollar could hurt gold and oil recovery in the short run.
In the Yahoo! Finance chart above, year-to-date UUP (the top pink line) has gained 8.45%. Meanwhile the SPDR Gold Trust (GLD), center blue line, has only added 0.78%. And the U.S. Oil Fund (USO), the bottom red line, is down 7.39%.
When it comes to the dollar-oil relationship, it is an overstated one. Even though the dollar is stronger than the euro by about 30%, oil prices are down about 50%.
In other words, the drop in oil prices is greater than the appreciation of the dollar. So, the dollar shouldn’t affect demand.
As for gold, if the dollar moves above 105, gold could make new lows.
Remember, the all-in cost for gold is about $1,100. Below that price, producers will probably cut production and supply and demand can eventually achieve equilibrium and price stability.
As for the dollar, the futures market and many others suggest it can head higher from here.
My take is that the latest rally has been almost parabolic. This type of move is generally not sustainable when the U.S. doesn’t have a major economic trend like the Internet boom to boost growth and wealth.
However, I’m going to keep a close eye on the futures markets. If the “smart money” is going long the dollar here in the short term, it may be a good bet that other money is going to follow.
Good Investing,
Dan Hassey
