The US Dollar Index’s Seasonality As Barometer For Stocks

``Debtors benefit from inflation and creditors lose; realizing this fact, older historians assumed that debtors were largely poor agrarians and creditors were wealthy merchants and that therefore the former were the main sponsors of inflationary nostrums. But of course, there are no rigid "classes" of creditors and debtors; indeed, wealthy merchants and land speculators are often the heaviest debtors.”-Murray N. Rothbard A History of Money and Banking in the United States: From the Colonial Era to World War II

We have been suggesting that the fate of the US dollar will be the key to the directions of financial asset pricing.

In last week’s Gold As Our Seasonal Barometer followed up by a mid week post Gold As Our Seasonal Barometer (For Stocks) II, we offered another contrarian perspective for analyzing the direction of pricing equity securities.

Instead of ruminating over the seasonal effects of September which has been statistically inauspicious for stocks, we suggested to look at gold instead.

Since US dollar has been the traditional and ideological archrival of gold, from which the former today has been continually bludgeoned even in face of some pressures in select asset markets (say in China), and even considering the combined developments in the political and economic front, any selling pressure is likely to be felt in the US dollar than in stock markets, and thus we proposed gold as a seasonal barometer for stocks.

We finally found two charts confirming the inverse of correlation of gold and the US dollar index.

Figure 7: US Global Investors: Inverse Correlation of Gold and the US dollar Index

Mr. Frank Holmes of the US Global Investors noted that ``September is only second to December in terms of dollar weakness, the average result for the U.S. Trade Weighted Dollar Index (DXY)(13) being a 0.66 percent decline from August. Looking at the 39 Septembers going back to 1970, the dollar has seen negative performance 26 times, more than any other month of the year.” (emphasis added)

Of course I won’t deny my “guilt” of looking for information to confirm my bias over my persistent focus on the US dollar.

That’s because it seems quite naïve, for anyone in my view, to believe that events of the last quarter of 2008 will replay itself in terms of a banking system gridlock, the main source of the US dollar’s rally last year.

That’s an old passé story. Society has learned from last year’s banking shock.

Instead, it would seem like an unnecessary distraction, coming from the mainstream macro perspective, still preoccupied with the deflation bogeyman.

Managing Inflation Expectations

What seems to be more of the locus of political attention has been to keep the price level system afloat through the inflation process.

Mr. Axel Merk of Merk Investments hits the nail on its head with his latest commentary, (all bold highlights mine)

``The conclusion we draw from the Fed’s talk about exit strategies and focus on inflation is mostly just that: talk. While we understand why the Fed is talking – to manage inflationary expectations – we believe the Fed may be playing with fire at our expense.

``Indeed, following Bernanke’s textbook, our interpretation is that the Fed may want to have inflation; and to get there, he may want a cheaper dollar, a substantially cheaper dollar. Bernanke has repeatedly stressed how going off the gold standard during the Great Depression jump started economic activity by allowing the price level to rise (read inflation). Fast-forward to today and think about all those homeowners “underwater” with their mortgages. We could allow those who cannot afford their homes to downsize, i.e. allowing market prices to clear by allowing foreclosures and bankruptcies, amongst others; however, that option seems to be political suicide. An alternative is to induce inflation, allowing the price level to rise; the Fed may not be able to control what prices will rise, but seems to be betting on home price inflation.

``Looking at what at the Fed does, rather than what the Fed says, we believe it is actively working on a weaker dollar.”

Indeed, action speaks louder than words!

From Bloomberg, The Federal Reserve ``bought a greater-than-average amount of mortgage bonds for a second straight week, following a period of reduced purchases…Net purchases totaled $25.4 billion in the week ended yesterday, compared with a weekly average of $23.3 billion since the Fed began the initiative in January, according to data posted on the New York Fed’s Web site today and compiled by Bloomberg.”

The US Dollar Carry Trade?

Besides, the selling pressure won’t just emanate from policy induced inflations, but this time it could be compounded from the lower interest rates spreads.

Figure 8: Wall Street Journal: Dollar Now Cheaper to Borrow Than Yen

For the first time in 17 years, Japanese rates have now popped above US rates.

According to the Wall Street Journal, ``On Wednesday, banks seeking dollars had to pay 0.37188%, which is the three-month dollar Libor, while yen borrowers needed to pay 0.38813%. It is the first time since May 1993 that the rates have flipped.” (emphasis added)

Implication? The US dollar could function as a funding currency for a global carry trade.

There have been worthwhile arguments posited against the US dollar as a funding currency due to its huge current deficits, low savings and heavy borrowing requirements since these are likely to induce relatively higher interest rates.

However, for the time being, it is likely that the US could be earnestly trying to attract capital flows into its system to finance its twin deficits by offering its currency for short term asset arbitrages in “target” (high yield) currencies.

Nevertheless even if we could be wrong here, the actions to bring down interest rates to produce inflation (nearly a Swedish nominal negative interest rate policy approach where banks have to pay interest to its central bank for them to accept deposits) simply exhibits how the US dollar remains under heavy strain.

Bottom line: Inflation is a political process. It would be difficult, if not suicidal, to take a contradictory stand against US authorities, when we recognize that the policy thrust has been to use the technology known as the printing press, to achieve a substantially reduced purchasing power for the US dollar.

In short, don’t fight the newly reappointed Ben Bernanke.