On the Precipice

2008-JUN-28

It has been my view expressed in these alerts and elsewhere over the past several months that there will be a currency crisis this summer caused by a plummeting US dollar. Summer of course began a few days ago, so it is reasonable to ask whether my view has changed. It hasn't.

The US dollar is now standing on the edge of the precipice. In fact, it is already peering over the edge as we can see in the following chart of the US Dollar Index.

There are several important observations to make from this chart. First, the dollar is in a major bear market. It peaked at 120.97 on July 5, 2001 and has been declining ever since within the major downtrend channel delineated by the red parallel lines.

Trends do not change unless there is some solid fundamental reason for them to change. There is only one way to strengthen a currency - raise interest rates. The Federal Reserve again failed at its FOMC meeting this past week to raise rates. So the only logical and prudent assumption is that the downtrend in the dollar will continue.

The second observation from the above chart is that the Dollar Index has been in a steep decline since early 2006, and more to the point, that decline gathered momentum along the way. The arrow on the chart marks the dollar's descent over this period. Note particularly how the arrow curves downward. It highlights the building momentum that caused the Dollar Index to fall last year to a record low on September 29, 2007.

Third, after making that record low, the Dollar Index bounced for only a few days, and then reversed course and resumed its downtrend. That action signaled profound weakness in the dollar, and sure enough, from its reaction high of 78.67 on October 8, 2007, the path for the dollar was basically straight down. It fell to a new record low of 71.33 on April 22, 2008, which equates to a stunning 17.3% annualized rate of depreciation.

The fourth and final observation is that since making this record low the Dollar Index has bounced. It is correcting the previous decline within the narrow uptrend channel marked by the green parallel lines. It is truly a so-called 'dead-cat' bounce. The best the Dollar Index could do was bounce to 74.15, retracing only 38% of its previous decline. But that is an overstatement because the Dollar Index traded above 74 on only one day, and did so simply because of the jawboning from Bernanke, Paulson and everyone else they could enlist to talk up the dollar.

As I stated in the last alert, which was posted just after the barrage of rhetoric, Bernanke and Paulson 'are trying to change monetary history by ignoring this most basic principle of central banking. Rather than raise dollar interest rates, they are instead just jawboning' and 'higher interest rates rather than more rhetoric are needed to save the dollar from a total collapse...[because]...the fundamentals for the dollar are horrific.' In particular, as the rate of inflation worsens daily, inflation-adjusted interest rates become more negative. This condition is extremely bearish for the dollar. So will the dollar collapse this summer? Yes, I expect so.

The odds still favor a collapse. Nothing has happened - so far at least - that could cause the major long-term downtrend illustrated in the above chart to change. So assume this trend will continue, and more to the point, that the collapse in the dollar I have been expecting for this summer begins when the Dollar Index breaks down from its current uptrend channel marked by the green parallel lines.

Given that the Dollar Index is now sitting on the bottom line of that uptrend channel, it is peering over the precipice. The dollar may get pushed over the precipice this Thursday if the European Central Bank raises Euro interest rates to fight the worsening inflation menace.

The following gold chart is giving us an important hint as to what lies ahead. Note that gold has already broken out to the upside from its narrow downtrend channel.

By climbing out of its downtrend channel already, gold is leading, that is when viewed in terms of US dollars. Gold has not yet broken out of its downtrend channel in terms of the Euro, but appears ready to do so.

I conclude from the above charts that even if the ECB raises Euro interest rates on Thursday, it will not stop gold from climbing higher. The ECB is 'behind the curve', though clearly not as far behind as the Federal Reserve. The inflation genie has well and truly escaped from the bottle.

Get ready for whatever the central banks throw at us by their mismanagement of national currencies. Own gold and silver.