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mhn

Dollar Rally

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Dear Mr. Salsman

Do you think that the US dollar rally of late can last or are we in a long term US dollar bear trend? And given your answer, what is your forecast for interest rates at this juncture?

Thank You

Michael

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This is Richard Salsman's reply to the question posed by mhn.

Yes, the 2005 dollar rally can last - at least for another year. Before 2005 began my firm predicted that the dollar's appreciation would occur in the first place - and this, on the heels of predicting the dollar's 3-year decline in 2002-2004. In this context, whenever people speak of "the U.S.  dollar" they mean the greenback's value in terms of other fiat paper monies issued by governments abroad. It's precisely in this respect that I project the dollar to continue strengthening over the coming year; but it should also strengthen against tangibles, such as oil and gold - which is another way of saying the gold price and oil price (both in dollars) should decline.  We've already seen the gold price begin its descent; the oil price should follow that path over the coming year.

All else equal a stronger dollar, especially versus tangibles, suggests lower interest rates, especially lower long-term rates. As we know, the Federal Reserve has been fighting this trend for the past year, in the process tripling short-term interest rates (from 1% to 3%). If the Fed persists in this maniacal policy, to the point of bringing short-term interest rates above long-term rates, it will contribute to yet another bearish period for U.S. stocks and the economy. The last time the Fed "inverted" the yield curve was 2000-2001 - and we all know the harm that followed. That was consistent with the harmful aftermath of past inverted yield curves. 

Punitive Fed policy aside, I should stress that a strong dollar is usually positive for investors in dollar-denominated securities, at least with a time lag.  After all, it was the U.S. Treasury's strong-dollar policy in 1995-1998 that subsequently lowered inflation expectations, commodity prices and Fed-controlled short-term interest rates - with bullish equity results (1995-1999). And it was Treasury' weak-dollar policy in 1998-1999 that subsequently raised inflation expectations, commodity prices and Fed-controlled short-term interest rates - with a bearish equity results (2000-2002). Having weakened the dollar again in 2002-2004, the Treasury once more set the stage for Fed rate hikes (which have been enacted since June 2004) - and for deleterious equity results, should the yield curve invert again.

Richard M. Salsman, CFA

President & Chief Market Strategist

InterMarket Forecasting, Inc.

1777 Fordham Boulevard - Suite 202-4

Chapel Hill, North Carolina  27514

EMAIL: RMSalsman@intermarketforecasting.com

WEB: intermarketforecasting.com

IFI is an investment research and forecasting firm that quantifies market-price indicators to guide the asset allocation decisions and trading strategies of pension plans, asset managers, financial institutions and hedge funds.

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Hi Richard:

If I understand you correctly, you suggest that a strong dollar would be accompanied by *lower* interest rates. Isn't it the opposite - or at least that's my understanding? It also appears that the dollar strength so far this year has been associated with rising rates.

Also, just out of perverse curiousity, is there any talk in the "trade" about how much money Warren Buffett has lost so far going short the dollar? The last time I read anything about it was some months ago when Buffett was still predicting a much weaker dollar - and at that point he had already lost several billion I believe. It's got to be much higher now.

Fred Weiss

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This is Richard M. Salsman's reply to the question posed by Fred Weiss.

By "stronger" dollar is usually meant an appreciation in the U.S. dollar in foreign exchange - that is, a rise in the dollar in terms of other fiat paper monies. So far this year the dollar has become worth more in terms of yen, euro and other foreign currencies. As I've stressed, so long as such a rise is accompanied by strength relative to tangibles (like gold), the result will be declining interest rates - with the decline especially likely in bond yields, since the Fed can always defy market trends and raise short-term rates despite a strengthening dollar (as it's been doing for the past year). A rise in the value of the dollar in terms of tangibles like gold is the same thing as a decline in the dollar-gold price. The gold content of the dollar (how many ounces of gold a single dollar buys) is, of course, merely the reciprocal of the dollar-gold price; and since the dollar-gold price has declined this year (from $446/oz in mid-March to $420/oz today), the gold content of the dollar has risen (by 6.2%, from .002242 to .002381). Thus the dollar has risen against foreign fiat paper monies AND against the most crucial, tangible good: gold. T-Bond yields today are roughly 4.1% - or 70 basis points lower compared to their peak in 2004 - due to the shift from dollar weakness to strength.

You should find nothing paradoxical about this pattern - namely, a stronger dollar accompanying and anticipating lower interest rates and a weaker dollar accompanying and anticipating higher interest rates. All other factors equal, this is perfectly logical (and historically true). After all, a stronger dollar is a dollar that's appreciating in value - that is, rising in purchasing power; amid such strength lenders of dollars will demand lower interest rates, because they expect to be repaid in more-valuable dollars; likewise, a weaker dollar is a dollar that's depreciating in value - that is, declining in purchasing power; amid such weakness lenders will demand higher interest rates to compensate for their perfectly rational expectation of being repaid in less-valuable dollars.

Perhaps your surprise that the "opposite" pattern isn't true reflects the basic (and widely-held) premise that "the interest rate is the price of money," hence that a more valuable dollar "should" imply a lesser supply of dollars and - in turn - should mean a higher price for dollars ("a higher interest rate").  But this premise is false - indeed, the reverse of the truth. The price of money (set at the intersection of the supply and demand of money balances) is the purchasing power of money; the interest rate is not "the price of money" but the price of loanable funds (set at the intersection of supply of savings and demand for savings - or investment).  The interest rate is, of course, influenced by the price of money (by fluctuations in its purchasing power, as I've spelled out above), but only because in the U.S. loans themselves are usually made and repaid in dollars.  But to believe - as Keynesians (and some misguided Austrians) believe - that the interest rate is "the price of money" is to effectively believe that lower interest rates can be achieved by rapidly printing a greater supply of money; but that's impossible: excess money creation (a creation of supply in excess of the demand for money balances) is inflationary and rising inflation expectations don't lower interest rates - they raise interest rates. I have already treated this issue - and its popular confusions - at some length in Part I of my series on the Great Depression (see "The Intellectual Activist," June 2004). This same fallacy has confused people about the cause of the Depression.

As for Buffet's dollar positions through his firm, Berkshire-Hathaway, Reuter's reported in March that in 2004 "Buffet's [bearish bet on the dollar] was profitable; Berkshire reported a $1.84 billion pre-tax investment gain on the contracts, up from $825 million a year earlier. The gain was $1.63 billion in the fourth quarter alone." But in the first quarter of 2005 Buffet lost $310 million on these positions and last May he said he'd boost his bearish dollar bet to $21 billion (see Buffet's Dollar Bet," The Wall Street Journal, May 3, 2005, p. A16). Buffet became bearish on the dollar far too late (in 2004, whereas I became bearish in spring 2002) - and in 2005 he runs the risk of losing as much (or more) money on the dollar than he made in 2004. I finally turned bullish on the dollar late last year - and it has risen in 2005; Buffet, in contrast, has persisted in his bearishness and is now losing very large sums.

Richard M. Salsman, CFA

President & Chief Market Strategist

InterMarket Forecasting, Inc.

1777 Fordham Boulevard - Suite 202-4

Chapel Hill, North Carolina  27514

EMAIL: RMSalsman@intermarketforecasting.com

WEB: intermarketforecasting.com

IFI is an investment research and forecasting firm that quantifies market-price indicators to guide the asset allocation decisions and trading strategies of pension plans, asset managers, financial institutions and hedge funds.

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Thank you, Richard, for taking the time to provide such a detailed response.

If I understand you correctly, while the dollar has been appreciating recently vis-a-vis other currencies and gold even while interest rates have been rising, your view is that it is *anticipating lower interest rates*. I assume you realize there's some very suggestive investment advice implied in that (in regard to bonds, for example - not to mention the stock market). Is that your view?

How do you - and apparently dollar buyers - see interest rates going lower in the face of what appears to be the Fed's commitment to raising them?

Fred Weiss

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As a follow-up to your answer on the value of the dollar, I wonder if you would comment on the recent revaluation of the yuan. I see that China tried to increase the value of their currency against the dollar (probably for political reasons to appease US policy makers), but recently it appears the dollar is gaining against it anyway. I know that such money is only fiat, but can a government really effect relative values of currencies--won't the markets make their own determination?

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This is Richard M. Salsman's reply to the question posed by Fred Weiss.

Yes, I realize that "there's some very suggestive investment advice implied" in my outlook for a stronger dollar and lower bond yields in the U.S.  That's why clients pay me for investment advice. 

As for how I see interest rates going lower "in the face of what appears to be the Fed's commitment to raising them," please make sure that you distinguish between long-term interest rates (bond yields) and short-term interest rates (the Fed Funds rate or the 3-month T-Bill rate). The Fed has far more control over short-term interest rates than it does over long-term interest rates. And although both long-term and short-term interest rates usually move in the same direction contemporaneously, there's nothing contradictory about their sometime moving in opposite directions. Indeed, prior to recessions and bear markets, bond yields tend to move down while short-term interest rates move up, to the point where long-term interest rates trade below short-term interest rates (known as an "inverted yield curve"). In June 2004 the 10-year Bond Yield averaged 4.75% while the Fed Funds rate averaged 1%, so the "spread between the two was 3.75% points. Six months ago the spread was down to 1.67% points. Today the spread is a mere 0.80% points (a bond yield of 4.30% versus a Fed Funds rate of 3.50%). The Fed seems intent on inverting the yield curve again - causing a negative spread between the bond yield and the Fed Funds rate - just as it did from March 2000 to April 2001. The Fed has done this roughly a dozen times since the late 1920s - usually with harmful effects.

Richard M. Salsman, CFA

President & Chief Market Strategist

InterMarket Forecasting, Inc.

1777 Fordham Boulevard - Suite 202-4

Chapel Hill, North Carolina  27514

EMAIL: RMSalsman@intermarketforecasting.com

WEB: intermarketforecasting.com

IFI is an investment research and forecasting firm that quantifies market-price indicators to guide the asset allocation decisions and trading strategies of pension plans, asset managers, financial institutions and hedge funds.

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This is Richard M. Salsman's reply to the question posed by drsm.

China didn't merely "try" to increase the value of its local currency (the yuan) against the U.S. dollar recently - it actually did so (by 2.1%).  And no, the dollar has not "gained" against the yuan since then; today the dollar remains 2.1% lower against the yuan than it did before China's re-valuation (on July 21st). It's true that the dollar has continued to gain against other currencies, as I've been expecting, but it certainly hasn't gained against China's yuan. Markets currently expect that in the coming year China will revalue the yuan a few more times, at roughly 2% each. 

You're right that China is doing this to appease U.S. central planners and politicians who fear Chinese exports to the U.S. For months these statists have been threatening to impose new tariffs (taxes) of as much as 28% on such goods. By raising the yuan versus the dollar China lowered the dollar versus the yuan; protectionists in the U.S. believe this will make it more expensive for Americans to import Chinese goods, so they'll import fewer of them.

China actually did something quite rare for a backward country and economy: it re-valued and re-pegged its currency instead of "floating" it and then sinking it. Let me explain. For the past decade China has "pegged" its yuan to the U.S. dollar, which means it issued (and withdrew) yuan while buying (and selling) dollars every day, to keep the yuan at a fixed rate to the dollar. On July 21st China raised the dollar value of the yuan by 2.1% and continued maintaining a (new) fixed rate each day.  All else equal, this will be a positive for China. In the past most backward nations - even those which had the good sense to link (peg) their currencies to the dollar - periodically broke those pegs and let their currencies "float" (i.e., change in value every minute), with the usual result that the value of their currencies plunged against the dollar; that brought rising inflation expectations, sky-rocketing interest rates, economic-financial chaos and bankruptcies. The most recent examples of this occurred in Southeast Asian nations (1997-1998) and in Argentina (2001-2002).  On July 21st China did not move from a pegged currency regime to a floating regime; it moved from one pegged rate to another - and it raised the value of the yuan. As a result, China will attract more foreign capital.

While recognizing that all currencies today are fiat monies, nevertheless you ask if governments can "really affect relative values of currencies" and "won't the markets make their own determination?"  Fiat money is a government money monopoly; under such a system only the GOVERNMENT can issue the money (there are laws against counterfeiting) and when it does so you (as a local citizen) MUST use such money (see legal tender laws).  So how can you doubt that such a monopolist can influence the value of his "product?"  Of course he can - by issuing more or less of it, at varying rates. Yes, foreign exchange traders buy and sell fiat currencies, but they are buying and selling monopoly products issued by governments; currency traders are the messengers, not the message.  Government currency issuers - not currency traders - ultimately determine the value of the currencies they issue.

It was the alleged free market economist Milton Friedman who gradually convinced the economics profession (starting in the 1950s) that a system of floating fiat currencies was a "market-based monetary system." Simultaneously, he condemned monetary regimes of fixed exchange rates (and the concept of money as a yardstick representing a fixed identity - such as the gold standard or a pegged currency regime) as a statist system of government "price controls." That's like claiming a system of weights and measures (which entails such identities as "one yard equals three feet") is "statist" while a system of "variable standards" (such as "a yard equals three feet one minute, but two feet the next minute, four feet the next, etc.) is a "free market" system. In this regard Communist China over the past decade has tried to maintain at least some vestige of a non-arbitrary, standard-based (free market) monetary system, while Washington has pressured China to adopt a more "flexible" (arbitrary-standardless-statist) system.

Richard M. Salsman, CFA

President & Chief Market Strategist

InterMarket Forecasting, Inc.

1777 Fordham Boulevard - Suite 202-4

Chapel Hill, North Carolina  27514

EMAIL: RMSalsman@intermarketforecasting.com

WEB: intermarketforecasting.com

IFI is an investment research and forecasting firm that quantifies market-price indicators to guide the asset allocation decisions and trading strategies of pension plans, asset managers, financial institutions and hedge funds.

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