Real Rates and USDX
It's funny, as a surprising number of mainstream analysts on CNBC in recent weeks are talking as if this dollar weakness is new. Apparently they have no historical charts. The dollar, as measured by the flagship US Dollar Index (USDX), has been in a secular bear market since July 2001. It has lost 39.2% of its value since then.
And believe it or not, contrarians were well aware of the dollar's peril even at its very top. Just two weeks after its apex, I penned an essay called "Real Rates and Gold". It discussed a coming "spectacular gold rally" and a "horribly debased US dollar". On a lazy July Friday in 2001 when gold closed at $270 and the USDX at 117, I wrote...
"So what is a central banker to do? Stop lowering interest rates and risk a huge implosion of the fragile US equity markets or keep lowering interest rates and push real rates negative risking a huge gold rally and eviscerating the dollar?" Provocatively, this old paragraph nicely reflects the Fed's dilemma in 2008 too.
Although few remember today, the key catalyst that got early contrarians excited enough to buy gold in the $260s when everyone else scoffed at it was negative real rates. Thanks to Alan Greenspan's aggressive rate cuts designed to bail out NASDAQ speculators, by the summer of 2001 real rates looked to plunge decisively negative for the first time since the 1970s. It was incredibly bullish for gold.
Real interest rates are simply the nominal headline yields that bond investors earn in "risk-free" US Treasuries less the rate of inflation. Normally real rates are positive, investors earn a nominal return higher than inflation. But sometimes the Fed drives real rates negative, forcing real losses in purchasing power upon bond investors. Inflation erodes their investments faster than nominal yields grow them.
Over the years since 2001, gold and gold-stock investors and speculators (including our subscribers) have earned fortunes trading on this negative real-rate thesis. I ended up writing 9 essays on this thread of research, the most recent of which was September 2007. Whenever the Fed willingly chooses to render bond investing unprofitable, investors move capital into gold to thrive despite the Fed's attack on them.
Sadly today, just like in the 1970s, the Fed is once again trying to rob investors. We have a Fed chairman hellbent on dropping nominal interest rates to zero, all in the name of bailing out irresponsible real-estate speculators that fully deserve all the losses coming to them. Meanwhile the Fed is ramping up the money supply at truly frightening rates, unleashing tremendous inflation. We're in a perfect monetary storm.
Since Ben Bernanke started slashing rates in a panic in September 2007, real interest rates have fallen faster and farther than anything witnessed since the 1970s! Even as a long-time student of real rates, I find this plunge stunning. Thanks to this slashing campaign, global investors can no longer earn positive returns after inflation in shorter-term US Treasuries. So naturally they are exiting the US dollar to search for greener pastures elsewhere.
In such a hostile environment for investors, the new all-time USDX lows aren't surprising. Last May I warned they were coming. But as I've pondered them recently, I realized I've neglected a key research thread. I'd never directly compared the USDX with real rates, only gold. So this week I thought it would be interesting to examine the dollar's fortunes through the lens of real interest-rate trends.
To calculate real rates, I'm following the same conventions from my real rates and gold studies. The nominal interest rate used is the yield on 1-year US Treasury Bills. While not widely traded today, the Fed maintains this data series. It is rendered below in black. For inflation, I am using the year-over-year change in the Consumer Price Index (white). Nominal rates minus inflation equals real rates (blue).
Now I fully realize the CPI is a joke as Washington has huge incentives to radically understate inflation in its headline index. Nevertheless, the CPI is widely accepted today by mainstreamers as the definitive inflation gauge. So I'm using this lowballed index here which really understates my case. If real monetary inflation was used instead, as it ought to be, real rates would look far worse than they do in these charts.
While the heavily manipulated CPI is showing 4.3% absolute annual inflation per its latest read, monetary inflation is far worse. Bernanke's Fed has ramped the MZM money supply by an eye-popping 15.4% over the past year! And this is its absolute year-over-year change, it is not annualized. Thus true inflation in the US is probably pushing double digits today despite what the CPI is trying to convince us.
I did change one key thing with this USDX comparison versus my earlier gold work. Instead of using monthly data for this multi-decade chart, I upped the resolution to daily data to try and better reveal real-rate extremes. The CPI is still only available monthly of course, but it can be compared to daily T-Bill yields. Thus there are nearly 30k data points in this first chart. The USDX is superimposed on top in red.
Real interest rates are a powerful trading indicator, but it is important to realize their signals operate at a secular scale. The USDX, or gold for that matter, will not usually instantly respond to real-rate changes. This is not a tactical day-trading indicator. Nevertheless, it doesn't take too long for investors to catch on to real-rate trend changes and start moving their capital into and out of the dollar and gold accordingly.
I think the easiest way to digest this chart is to follow the dollar's journey since 1971 through the lens of real-rate trends. In the 1970s real rates were low or negative most of the time, and the USDX ground lower on balance throughout the entire decade. Interestingly the USDX tended to be the most stable when real rates had been climbing and were positive, such as in 1976.
The 1970s are also interesting as they prove that Treasuries investors pay careful attention to inflation too, not just nominal yields. In 1978, for example, T-Bill yields averaged 8.3%. This sounds very impressive in isolation, investors today would kill for such a yield. Nevertheless, inflation ran so high that real rates only averaged 0.7% that year. And the USDX suffered for it, down 10.3% in calendar 1978. Investors do watch CPI inflation!
Real rates bottomed at -6.75% in June 1980. Interestingly this was due to YoY CPI inflation growth still running at 14.4%, not immediate Fed action. 1y T-Bill yields had hit an interim peak a few months earlier at 16.5% in March 1980 but were down to 7.6% by June. Paul Volcker's inflation fighting, started soon after his August 1979 appointment as Fed Chairman, didn't take long to start bearing fruit. Americans had to pay a heavy price for the inflationist Fed of the 1970s, a hard lesson Ben Bernanke has apparently forgotten.
Provocatively the USDX bottomed in July 1980 just one month after real rates bottomed. Global investors started buying the dollar again even when real rates were still negative because Volcker's inflation-fighting campaign was credible. By May 1981 real rates had rocketed back up to +7.1% and investors were scrambling to buy dollars and Treasuries. 1y T-Bill yields ran 16.9% but inflation had fallen to 9.8%.
While nominal rates soon came down, for almost all of Volcker's reign until August 1987 he kept nominal interest rates well above inflation. You can see this above with the blue line oscillating between 4% and 8% in much of the 1980s. With the real yields so high in sovereign US debt, international capital flocked to the dollar. The USDX went parabolic and topped at a staggering 164.7 in February 1985. It had soared 95.8% since July 1980!
While this parabolic ascent had to be followed by a crash in purely technical terms, the dollar didn't have to fall as far as it did. If real rates had stayed so high and favorable, it probably would have bounced between 130 to 140 on the USDX. But real rates plunged from 8.1% in June 1984 to 2.1% in October 1987 just after the infamous stock-market crash. Over this span, the USDX fell 30.9% to 94.
Thus it seems crystal clear that falling real rates really mattered to investors. Their demand for the dollar and US Treasuries waned with falling inflation-adjusted returns. This trend actually continued to October 1992 when real rates briefly fell negative. Provocatively just one month earlier in September 1992, the USDX hit an all-time low of 78.33 as real rates threatened to go negative. The USDX lost 52.4% in that secular bear driven by falling real rates.
After Alan Greenspan finally raised rates six times in 1994, real rates stabilized for the rest of the 1990s around 3% or so. While this wasn't a great yield, it did still help attract in international capital. So the USDX began a long 50.6% secular bull from April 1995 to July 2001. What ended this particular dollar bull? Thanks to Greenspan's aggressive rate cutting in 2001 to bail out stock speculators, real rates were heading to zero.
Today a lot of mainstream analysts attribute the USDX's mighty bull of the late 1990s to the strong US stock markets. While attractive stock markets don't hurt, real rates were likely a far more important factor in the dollar's strength. The USDX's bull started soon after real rates went above 3% in 1995 and it ended when they fell to 0% in 2001. Interestingly by the time the USDX peaked, the SPX and NASDAQ were already down 20% and 59% from their early 2000 highs. Real rates, not stocks, drove the USDX.
Since its July 2001 peak, the USDX has fallen on balance in a relentless 39.2% secular bear. Real rates remained low or negative for most of this period. There was one spike in 2006 which I will discuss below, but it didn't last. As long as international investors have little hope that the Fed is willing to set interest rates at reasonable levels above inflation rates, they have no reason to buy US dollars.
The moral of this long-term dollar story? Real rates are probably the single biggest factor affecting the dollar's secular fortunes. The USDX has never enjoyed a secular bull without healthy positive real rates. And it has never experienced a secular bear without falling or negative real rates. So if you want to game the US dollar's secular trend, see how its sovereign debt is yielding relative to domestic inflation.
My next chart zooms in to examine today's secular dollar bear since 2001, the portion of modern history most relevant to us now. Even at this much shorter scale, the influence of real rates on the dollar's fortunes is readily apparent. Inflation-adjusted yields are truly a huge factor in international investors' decisions on whether or not to deploy capital in dollar-denominated debt investments.
While the USDX technically topped in July 2001, it made a slightly lower secondary top in January 2002. Note that its behavior between these tops approximates real rates pretty well. The USDX really started plunging when real rates again fell under 1%. I doubt bond investors believed the CPI though, that inflation was only running 1.1%, in early 2002. So they probably already perceived real rates as negative.
Provocatively the USDX didn't carve the first sustainable low of its bear until December 2004 when real rates were finally heading positive again. The USDX kept rallying with rising 1y T-Bill yields into late 2005 when CPI inflation again outpaced nominal yields. With real rates still under 1%, the dollar started lower again but it remained well above its late 2004 lows. The USDX was indeed stabilizing as real rates rose.
Then in September 2006, real rates skyrocketed to 3%. You'd expect these healthy real rates would lead to serious dollar buying, but they didn't this time around. This whole gain in real rates was due to a big drop in the CPI in September and October 2006. But this coincided with a CPI calculation methodology change and I don't think international investors believed it. 1.3% inflation in late 2006? No way.
After this suspicious CPI ebb, underlying monetary inflation forced even the "new-and-improved" CPI to rise. Real rates fell from 3% to 2% and dollar selling resumed. Interestingly this latest dollar selling was slow and controlled until Bernanke panicked in September 2007 and started slashing interest rates. This caused real rates to plummet and they have since been driven to -2% by the end of January, the latest CPI data available. It is today's dismal real rates that have driven the USDX's new all-time lows.
In light of this real rates and USDX history, investors and speculators can game the dollar's fortunes in the coming months. A new dollar bull is extremely unlikely until we see sustained, healthy real rates. Based on the precedent from the last dollar bull of the 1990s, I suspect 3% to 4% real is the level necessary. Not only do real rates have to get this high, but international investors have to believe rates will stay this high.
Three developments would be necessary to make this a reality. The CPI would have to moderate and nominal T-Bill yields would have to rise. And the Fed would have to command enough global credibility so that investors believed it intended to keep nominal yields high enough to support healthy real rates for a long time to come.
On the CPI front, falling headline inflation is unlikely no matter how much the government statisticians try to hide it. Food and energy prices are rising globally due to structural deficits, adding very visible price pressure. And MZM money is rocketing 15% higher annually guaranteeing higher general prices. No one is going to believe a falling CPI even if the government publishes it. In today's price environment, Washington simply can't report a CPI lower than 2% or 3% if it wants this index to maintain mainstream credibility.
On the nominal yields front, the Fed would have to raise rates dramatically from here. If the CPI stays at 4%, the Fed would have to raise rates an astronomical 400 basis points or so to get real rates to 3%! At a 2% CPI, the Fed would have to raise rates 200bp. In either case, the stock markets would plummet and Bernanke and his cronies would probably be tried for treason. No serious rate hikes are going to be politically feasible in today's credit-crisis-ridden economy for many months to come.
And even if the Fed could raise short-term rates to the 6% to 7% necessary to see 3% to 4% real returns in short-term Treasuries, would it have any credibility? After Bernanke's disastrous pro-inflation performance running the printing presses so far in his short term, would any investors believe he can be trusted? I really doubt it. We may need to see a new hardcore Paul Volcker-type Fed chair before any investors trust the Fed again.
Thus it looks like the kinds of positive real rates necessary to drive a secular dollar bull are unachievable in the foreseeable future. The US credit environment is so bad, and inflation due to the Fed's monetary growth so extreme, that nominal rates can't go high enough to yield healthy real rates. And if real rates stay low or negative, the dollar's bear market will only continue.
Since July 2001 our current dollar bear has bled 39.2%. This may seem extreme, but the USDX lost 52.4% in its last secular bear ending in September 1992. A similar loss in our current bear would yield a USDX level of 57.5! Ouch. This is another 22% lower from today's all-time dollar lows! So in light of historical precedent, there is plenty of room for the USDX to continue falling even from here.
As an investor I hate this prognosis. It makes my blood boil when the Fed declares war on me and tries to steal my hard-earned capital through inflation and negative real returns on cash. Thankfully there is a way to fight this central bank's depredations. By deploying capital in gold, silver, and precious-metals miners, investors can multiply their wealth through this difficult monetary environment far faster than the Fed can destroy it.
For a variety of reasons explained in depth in our new March newsletter, I expect a major rally in gold and silver stocks in the next few months. As such, we have been aggressively adding trades in elite gold and silver stocks. This real rates and USDX research makes the case for this tiny sector even more bullish. If the dollar continues heading lower as the Fed's disastrous negative real rates suggest it will, this is extremely bullish for gold and silver even at today's prices. And their miners will follow the metals.
So subscribe today to our acclaimed monthly newsletter to get ready for this potential monster rally. First-time e-mail-edition subscribers will get a complimentary copy of our new March issue outlining the bullish case. Your paid subscription will start next month. You can digest our logic, mirror our real-world trades, and prepare for what is likely to prove an incredibly profitable few months in precious metals.
The bottom line is the prevailing real-rates trend has a huge impact on the US dollar's trend. When real rates are healthy, international investors flock to the dollar to enjoy these yields. But when real rates are low or negative, investors flee from the dollar to avoid suffering losses after inflation. This makes perfect sense logically and is readily evident historically. Real returns matter.
Today we are stuck in an environment where the Fed insists on attempting to bail out real-estate speculators. But as the Fed's 2001 attempt to bail out NASDAQ speculators showed, artificially-low-rate campaigns always fail to accomplish their goals. They just prolong the misery. A major side effect of today's campaign is the falling US dollar. Until the Fed stops this foolishness, the dollar bear will continue.
Adam Hamilton, CPA
Mar 7, 2008
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