Dollar’s Last Gasp

Eludes Gold Bugs

Is the dollar about to break? The question is crucial for gold bugs, since the greenback’s strength has kept a lid on bullion prices since last March, when the dollar embarked on a 25% rally from historical lows. Over the same period, gold has dropped about 28% after hitting an all-time high near $1048. We see no technical evidence these trends are about to reverse, but that could change if the Dollar Index, which settled on Friday at 87.12, were to drop by about 1.5 percent in the next week or so.

So why should a 1.5% drop in the Dollar Index, from 87.12 to 85.82, be viewed by gold bugs as a sign that deflation is loosing its grip on precious metals? According to our technical runes, that would test a key Hidden Pivot support (see chart above) whose resiliency holds clues to the dollar’s future. If the support fails to produce a bounce, however – or worse yet, the index closes for two consecutive days beneath it -- that would suggest the dollar’s rally is starting to sputter out. This could conceivably occur if two or three consecutive Treasury auctions draw relatively few buyers. They are still turning out in droves, but we think their absolute preference for Treasury debt over high-grade corporate paper will eventually come to be seen as a manifestation of mass mental illness. Meanwhile, although we are willing to concede that a hyperinflation may be lurking somewhere down the road, we do not think that it will come in time to save debtors. To think otherwise is to implicitly believe that you and I will eventually be able to pay off our mortgages by selling our homes for quadrillions of dollars, or by using a tiny fraction of our billion dollar paychecks.

Why the dollar should be so strong is another question that has vexed the hard-money crowd, but the answer is simple: A massive, global short position against the dollar is being unwound. Remember, anyone who owes dollars is implicitly short them – and also implicitly hoping for inflation, since that would allow borrowers to repay creditors in cheapened dollars. In the past, servicing dollar loans was easy for most borrowers, since credit was plentiful, collateral values were rising, and it was easy to keep rolling the loans forward. Now, though, much of the collateral has become suspect, and creditors (other than the U.S. Government) are no longer able to provide easy terms. They are in fact demanding that borrowers settle up in cash, and this has pushed the dollar higher. Similarly, a short-squeeze has been pushing up the yen, but even more steeply. That’s probably because many trillions of yen that were borrowed from Japan’s central bank at rates of one percent or less were used almost exclusively for leveraged speculation.

Paradoxical Strength

How long is the dollar’s paradoxical strength likely to last? Our guess is that it will persist for as long as deflation continues to overwhelm the inflationary nostrums of the central banks. Right now, it’s like a contest between a grade school football team and the New York Giants. While it might seem like the trillions of dollars the Fed has put into play amounts to big money, it pales in comparison to the tens of trillions of dollars that have vanished from the financial system. Debt deflation is the cause of this, and it could take another six or seven years to runs its course, according to followers of Kondratiev Wave Theory who correctly predicted deflation well ahead of the event