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US Dollar Limbo: How Low Can it Go?

As I gear up for the holiday invasion and the ensuing gluttony that’s about to transpire, I can’t help but look forward to my next vacation.  I’m thinking somewhere tropical, perhaps the Caribbean, enjoying drinks with little umbrellas in them.  I lull myself into daydream, counting waves and sunsets as island music fills the air.  Yet all is not perfect.  And then it hits me like a ton of bricks—the calypso music I’m hearing is being played by none other than our esteemed Fed Chairman Bernanke!  He’s wearing a Panama Hat and a blousy Hawaiian shirt, playing a version of the Limbo: how low can you go!  Only the participants aren’t drunken tourists, but dancing US dollar bills, each trying to squeeze under a rapidly sinking bar to Bernanke’s amusement!  The pleasant daydream has now become a nightmare, as I realize that I can’t afford another Painkiller with the mountain of cash I place on the bar.  I awake in a cold sweat.  Thankfully it is just a dream.  Or is it?

We are all aware of the trying economic times we are experiencing and the fact that we haven’t gone off the cliff (yet) is something that I am thankful for.  Now that we seemingly have avoided Depression (again yet), we find ourselves mired in a serious recession and there is great debate about how to get out of it.

One of the prevailing themes and the one espoused by those charged with figuring this out is that the path to prosperity is through dollar destruction.   Since the dollar has been tanking thanks to Bernanke’s zero interest rate policy (ZIRP), both the stock market and the commodities markets (particularly gold) have seen tremendous gains (relative to where they were before last fall) as well as other currencies.

This has led to the “tale of two trades”, which I have outlined in previous articles.  The irony of this is that in order for the dollar to advance, we need to see inflation so the Fed will raise rates.  The fact that we are not seeing inflation but rather serious deflation means that the dollar will continue to fall until it reaches its “breaking point” whether we are out of recession or not.

However, there is another way that the dollar can rise without raising interest rates.  It’s called the risk aversion trade and will come back into fashion as investors become more skeptical /less confident in the world and particularly the United States recovery.  I wrote recently about how the Fed massages the numbers and jaw-bones the dollar so at this point it shouldn’t come as a shock to anyone.

So if you want a stronger dollar, you have to be prepared to accept worsening conditions.  Things like GDP revisions and less-bad-but-not-quite-good-employment figures all keep the dollar from crashing.

So where is the breaking point for the dollar?  How low can it go?

Well rather than try to throw out some technical mumbo-jumbo, or attempt to rationalize the irrational, I’m going to leave you with this thought:  the Dollar will continue to decline until things look so bad that the US dollar carry trade starts to unwind as the “flight to safety” takes effect; or if conditions actually do improve enough for the Fed to raise rates. 

The first scenario is likely to happen more rapidly than the second.  The dollar funded carry trade is getting crowded so all its going to take is one timely placed comment or economic number to send everyone running for the door.  This will provide a temporary lift and is intended to buy the Fed time for the second scenario to happen.

The second scenario is a bit more involved and likely to cause the economy to “get worse before it gets better”.  Sacrifices will need to be made and I hope that we have the political fortitude to do so.

But until that happens, I’ll keep hearing those steel drums in my dreams and seeing those dancing dollars making new lows. 

So for this Thanksgiving I’ll be thankful that as of right now, they will still take dollars for my favorite Caribbean drink!  Anything else at this point is just gravy.

Happy Thanksgiving to All and be sure to check out our currency trading courses!

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