Trade Talks or Inflation — What is Really Behind the US Dollar Decline?


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There has been a lot of talk about the declining dollar with many speculating that it is being influenced by inflationary pressures, trade negotiations with China and excessive deficit spending. Does the buck really stop here?

The decline in the greenback that started in 2017 and continued into Q1 of this year, may not be done just yet. The US dollar entered a massive bull market in 2011 that boosted its value by 30% — a run that continued until January of 2017. This sell-off over the past year has left many investors hunting for the dollar&a;rsquo;s bottom. With four Federal Reserve rate hikes since the US dollar began selling off early last year, and an additional 2 to 3 hikes signaled for the remainder of 2018, anyone who believes in interest rate differentials as the prime mover of currencies would assume that the dollar should be appreciating. So, what is really going on?


Let&a;rsquo;s examine the relationship between the US dollar and REAL yields which is the difference between nominal rates and breakeven inflation rates. Economists and investors use this measure as a reliable indicator of expected inflation. Below, is the U.S. Federal Reserve Trade Weighted Dollar Index (white line) and the difference between the 2-year US Treasury yield and the 2-year breakeven inflation rate (orange line). If future inflation is expected to be higher, then real yields will be lower. This graphic is a useful visual examining how the market values the USD, relative to the return it earns in excess of future inflation.


&l;img class=&q;size-large wp-image-187&q; src=&q;http://blogs-images.forbes.com/bobhaber/files/2018/04/Bloomberg-chart-04-22-2018-1200×658.jpg?width=960&q; alt=&q;&q; data-height=&q;658&q; data-width=&q;1200&q;&g; US Trade Weighted Dollar Index

Historically, when there is a move up in the REAL yield rate differential, there is an immediate, sizable response of dollar demand because investors believe they will receive a higher return after inflation. But starting in mid-2014, the relationship between the two indexes began to deteriorate into the completely broken relationship that emerged between 2015 and 2018. During this unusual period, the US dollar began its bull run, yet the 2-year REAL yield, stayed flat. Since historically the US dollar and 2-year REAL yield need to converge, this chart tells us that the dollar has been massively overvalued since 2014.


Is it as simple as the dollar being overvalued or mispriced, or are REAL yield differentials about to jump up? We can check the fundamental value of the US dollar through purchasing power parity (PPP). PPP data allows economists and investors to compare the value of a basket of goods in one currency relative to another. Under this metric, the US dollar remains at or above fair value versus most other currencies (Ned Davis Research). There are two other periods in the last 45 years that saw an overvalued dollar start to adjust downward. In the late 80&a;rsquo;s and around 2000, after being severely overvalued on a PPP basis, the dollar went on a multi-year correction and eventually made its way to severely undervalued. In today&a;rsquo;s market, that is potentially another 15+% decline in the greenback from the current over the next few years!


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The key to this trend is inflation. I have often written about resurgent inflation and have been predicting that core inflation will climb near 3% by 2019. REAL yields are another victim of rising inflation. If US inflation outpaces trading partner inflation, REAL yields will decline putting the dollar at risk of further declines.

So what investments are worth holding in a declining dollar, higher-inflation period? I&a;rsquo;ve mentioned this before, but it bears repeating that commodities such as energy and base metals, (see indexes such as DBB, GSG, DBC, GCC) and precious metals such as gold and silver are the big insurance play here to protect against the declining dollar.&l;/p&g;

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