Prepare for QE5 : The Road to Financial Purgatory
By Joshua Enomoto, Founder of ContangoDown.com and CrushTheStreet.com contributor
Like a well-tuned Swiss watch, the financial media behemoth has been squarely focused on the sudden rise of the equities sector, in particular, the record shattering move of the Dow Jones Industrial Average. Thursday, March 28th added yet another milestone to the American bull market, with the S&P 500 index closing at 1,569 points, a session-finishing number that hasn’t been seen since…well, it hasn’t been seen at all, such being the way of the record break. But another bull market has also emerged (…and no, I’m not talking about Japanese stocks…), one that rarely gets mentioned because of its illogical nature.
I am referring to the US dollar.
Before the cries of hyper-inflationary policies by the inept Federal Reserve start pouring forth, let’s review the facts: while the Dow Jones rose over 16% from mid-November of 2012, the US dollar saw a lift of 5% in a two-month time frame between early February and late March of 2013. While that doesn’t sound like a whole lot, in the currency market, where volatility is measured in fractions, five percent might as well be a “two-bagger.” Over the last three years, the spread between the dollar’s absolute peak and valley measured 22%; for the Dow Jones, the spread is nearly 52%. From a simple ratio perspective, the dollar has had every bit of an impressive bull market as the Dow or the S&P500.
But how can that be?
This is where things start to get a little strange, with the present market behavior perhaps acting as a harbinger of a deflationary cycle. First, let’s consider the technical chart (6-month daily) for the US dollar index:
The current level of the index has retraced nearly 84% of the July 2012 peak, suggesting that this price action is no fluke. Something has energized the paper bulls, with a rising level of support ready to catch any downside risk at the upper 80’s. Also, a six month period where the faster 50 day moving average was below the 200 finally came to an end in late March 2013. Frankly, if we were discussing gold bullion, the gurus and experts would have jumped out of the woodwork with new calls of excessively dizzying heights, yet because this is merely a “worthless fiat currency,” the fervor is nonexistent.
Still, such a dramatic rise is hard to ignore. Despite one’s personal bias that would argue for the contrary, the actual data points to strength in the dollar. But can such a scenario be possible given the quantitative easing programs of the Fed? Let’s consider another technical chart for the Dow Jones (3-year daily chart):
The green line represents the price action of the dollar index, which starkly demonstrates the dichotomous relationship between the currency and the equities market. However, in late February, the inverse alignment came to an abrupt end, with the dollar and the Dow making near-term highs. Dollar strength is logical at this time, given the weakness in commodities and foreign currencies, particularly the Yen and Euro pairings with the greenback. But it does necessarily imply that equities are tremendous value plays, as each successive move higher in the stock market is accompanied by an equally higher moving currency: to put it bluntly, we have entered an arbitrage condition where hedging is no longer required.
But as with any pure arbitrage movement, such circumstances rarely sustain themselves: somewhere along this journey, a turning point will emerge. Back in late 2007, when the equity indexes were also breaking records prior to the financial collapse, the dollar index was roughly around the 82 level, but making its way sharply lower, at one point getting down to 71 in the spring of ’08. Immediately after the collapse, the dollar index shot up over 14% to nearly hit the 90 mark, which was reflective of the mood at the time: undervalued equities, low cost of goods, and an extremely strong currency.
The conclusion? Either the equities or the dollar moves higher from here, but not both. Forecasting the correct path, however, would inevitably lead to long-drawn debates, as no politician has the heart or the conviction to lead the country down to a deflationary cycle. Such being the present psychology, it’s hard to argue against the idea that the Federal Reserve is fully committed to prevent deflation and this could very well lead to QE5.
However, the Fed is running out of ways to inflate the currency without inflating real prices (balance sheet inflation vs. street inflation). Thus, any additional loosening programs could seriously undermine the stability of the financial system, further underscoring the importance of real assets. While limiting exposure to commodities may be wise during transitional cycles, an investor should be careful in cutting exposure altogether: with so much hanging on a delicate balance, even a small investment in tangible assets could pay off exponentially.