U.S. Dollar Risk Has Flipped to the Upside

By Andy Krieger, Editor, Money Trends

After the Georgia run-offs earlier this month, we saw aggressive buying of stocks and selling of bonds, and the dollar was initially pushed lower. The euphoric buying of stocks was based on two expectations…

One, that the Federal Reserve would keep rates effectively at zero for many years to come. And two, that the Fed would keep pumping in ridiculous amounts of liquidity indefinitely.

Speculators and investors alike went wild, bidding up equity valuations to absurd levels that bear no relationship to earnings. The value of U.S. equity markets is now 196% of U.S. GDP, an almost unimaginable level we’ve never seen before. 

However, I believe the yield on 10-year Treasuries is already reaching levels which will force a significant rethinking and repricing of equity assets and the dollar.

Effectively, the market has implemented the same moronic practices that drove the dot-com bubble to levels that were unsustainable, pricing stocks at crazy multiples of revenues.

I’ve written before about the dot-com bubble, and how that resulted in an 83% peak-to-trough collapse in the Nasdaq 100 after the market finally topped out. The current valuations are even more extreme and more disjointed from the real economy. How so?

As I write, we’re still recovering from one of the worst economic downturns in our country’s history. Unemployment remains painfully high, with only 60% of the jobs lost in the spring recovered.

We still have nearly 1 million new claimants for unemployment every week – numbers that are worse than the peak of the Great Recession.

The extremely low interest rates are proof of the economy’s underlying weakness. Strong economies do not require massive liquidity injections amounting to trillions of dollars, and they don’t need emergency fiscal spending packages.

Yes, we have Covid-19 vaccines now, which will be very helpful in getting things back towards some sort of normalcy over the next eight to 12 months. But much structural damage has been done already.

It will take a long time to heal the economy, and the Fed’s balance sheet and the federal debt are already at critical levels.

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The Fed’s balance sheet has ballooned by $7 trillion over the past 12 years – with more than $3 trillion of that happening in the last year. This expansion is unsustainable, and yet it’s far from over.

With the Democrats now in full control of the House, the Senate, and the executive branch of the government, we need to brace ourselves for very aggressive fiscal spending programs.

In fact, the new administration is wasting no time on this. Just days before taking office, Joe Biden proposed a new package of nearly $2 trillion – including additional stimulus checks of $1,400.

The massive additional fiscal stimulus we will almost certainly have will create significant economic demand. If this fiscal spending is implemented sensibly, the demand could be huge.

Coupled with the positive impact of the vaccines, this extra fiscal demand could lead to a demand shock.

Perversely, this much-needed boost in demand could lead to a fierce re-evaluation of stocks, since investors will be forced to anticipate higher rates much sooner than first anticipated.

You see, the massive Fed stimulus has not created a booming economy. 

Instead, it has largely fed a voracious appetite for risk-taking in financial markets. It has also supported booming demand for residential real estate as the cost of mortgages has crashed.

We are already seeing the impact of this housing boom in the form of higher input prices. Lumber and copper prices have soared since March (up 152% and 73%, respectively) as have other key commodities.

Once the vaccines are given on a widespread basis, even if they are less effective than hoped, and additional fiscal stimulus is thrown at the economy, additional economic growth is inevitable.

This will translate into upward price pressures and a rise in inflationary expectations – which will drive the 10-year yields higher.

The rising interest rates are going to create heavy pressure on investors to start reallocating some of their assets out of stocks and into fixed-income assets.

Higher rates could also have an effect on the forex markets. Here’s how…

Technically, the markets have the most overweight short U.S. dollar positions I have ever seen.

If interest rates rise much sooner than investors anticipated, we’re going to see a serious bid for the U.S. dollar. Whether this proves to be a correction or the start of a major reversal for the other major currencies is hard to forecast right now.

Historically, investors have plowed into the U.S. dollar when interest rates are rising due to strong growth, as long as inflation is largely under control.

We don’t have to worry about a sharp rise in inflation for quite some time, as the impact of 20+ million people still receiving some form of unemployment assistance will keep a lid on prices. Their families are struggling, and the market’s surging prices completely misrepresent the reality of today’s economy. 

Still, as I mentioned earlier, there are some budding price pressures. Eventually, as jobs return and the economy recovers on a broader scale, the rise in inflationary pressures could accelerate.

But for quite some time, it is safe to say that the risk in the U.S. dollar against most major currencies has flipped to the upside.

Regards,

Andy Krieger
Editor, Money Trends

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