Happy Australia Day!

Being a public holiday, the offices here at the Daily Reckoning are deserted. I’m not hanging around long either. I’ve got some lamb to cook and beers to drink. I can’t have my daughters growing up in ignorance of fine Australia Day traditions.

In my younger years, Australia Day usually involved The Big Day Out music Festival or going to a Friends’ house for a BBQ. Now, with two little kids, if I can squeeze in a few beers with lunch I’m happy.

I’m not one for flag waving or overt signs of patriotism though. Patriotism comes in many forms, and it doesn’t have to involve wrapping yourself in a flag.

Not that many people do, but I’ve noticed it’s become a bit of a thing amongst the young kids. And I still have memories of the horrendous Cronulla riots back in 2005. I was living in Sydney at the time and had a Lebanese mate living in ‘the shire’, right near where the riots took place.

I was genuinely worried for him. It was the worst Australia Day I’ve ever experienced.

Today should be a good one though. I hope you have a good one too.

Before I get on to the topic of money, a quick anecdote on the day we are celebrating. It comes from Robert Hughes’ awesome book, The Fatal Shore, a history of early colonisation of Australia.

On the 24 January 1788, the First Fleet sailed into Botany Bay. They went there first because that’s where James Cook landed eight years earlier, and they followed his advice. But Governor Phillip wasn’t a fan…it had no fresh water, so he decided to head back up the coast.

In turning around to get out of the bay, a few ships of the fleet sailed into each other in a nice display of maritime ineptitude. The locals watching from the shore were no doubt bemused.

Once finally out of the bay, the fleet headed back up the coast and on the 26 January, 1788, sailed into the magnificent Sydney heads, revealing to the exhausted and land starved crews what must have looked like the largest and most stunning harbour in the world.

They set up camp in Sydney Cove, where Circular Quay is today. The first few years were a tough existence. If only those on the First Fleet could see it today….

Today’s topic is a little unpatriotic, but money and the markets don’t know where you live, nor do they care.

In preview, it’s bearish on the Aussie dollar. More accurately, it’s bullish on the US dollar. Below is an edited version of a note I sent subscribers to Sound Money. Sound Investments. last week. If you’re interested in a trial subscription, you can check out my latest report, here.

This trend will become a tsunami

A few months ago, I posted a chart of the US dollar index under the title, ‘the most important chart in the world’. Perhaps that sounded a little over the top.

Believe me, it’s not.

Here it is again, but this time it’s a much longer term chart than you’ve seen before. Its shows the US dollar index over the past 35 years, on a weekly timeframe.

There are a series of trends that you can make out on this chart:

Uptrends, followed by downtrends, followed by basing patterns, followed by another uptrend.

The point to note is that they are long term. All these trends are multi-year.

Consider this:

Back in the mid-80s, the US dollar was a picture of strength. It reached a peak of 165 on the index (nearly 40% above the 2001‒2002 high point, or nearly 80% above today’s level) before the famous ‘Plaza Accord’ meeting conspired to bring it down.

After reaching a peak in 1985, it collapsed 50% by 1988 (sending global capital rushing into Japan and blowing up the Japanese stock bubble). As you can see, it made a final low in mid-1992, which was really part of a five-year basing pattern. Then the bull market got underway in 1995, and the index climbed by around 40% before topping out in 2001-02.

The period from 2008 to 2014 is a similar basing pattern to that experienced around 1991 to 1995.

On the balance of probabilities, you should now expect to see the US dollar trend higher for years to come. Of course, there will be corrections along the way…and the US dollar bears will come out growling when the corrections occur…but the charts are telling you to expect a major rally in the US dollar index.

Given that a big part of this index is driven by the performance of the euro and the yen, this expected strength in the US dollar shouldn’t come as a surprise. US debts might be high and unsustainable, but compared to the other options, the dollar isn’t looking too bad. In the world of currencies, everything is relative.

But the problem is that this coming rally will not be a benign one for the rest of the world. The incoming dollar tide will turn into a financial tsunami.

To explain why, you need to understand a bit of background.

The global carry trade

We start with the US dollar bear market that got underway in the early 2000s. It came about because of the ‘tech wreck’ and the lower interest rates that brought about. (Relatively low interest rates are usually bearish for a currency.) Among many other things, these lower interest rates and the weaker dollar sparked a massive global ‘carry trade’.

You may have heard of the term. It basically means that traders borrow in cheap US dollars and buy just about anything else in non-dollar terms: namely commodities, emerging market debt and stocks and currencies.

Traders benefit from a yield differential (if investing in, say, emerging market bonds) currency appreciation, or stock price appreciation. This carry trade was hugely beneficial to anyone playing it — and a lot of people did.

Nations, if unwittingly, played it too. China and Australia were a major beneficiary of this carry trade, as it contributed to a massive commodity price boom.

In fact, the commodity and emerging markets boom were just a mirror image of the US dollar bear market.

Emerging markets took off in early 2003, about a year after the US dollar began to weaken. Then they crashed after the greenback started to rise in 2008.

This tide of speculative money, fuelled by loose US monetary policy that began in the early 2000s, was a major trend. It lasted for five or six years.

But then a funny thing happened. After the 2008 crisis, the US Fed dropped rates again and started injecting even more liquidity via QE. While this didn’t knock the dollar down further, it did spark a reversal in emerging markets. The carry trade was back on, with a vengeance.

However, this time around it was more about playing the yield differential rather than punting on pure asset price rises. It was more selective than the 20022008 free-for-all.

Let me explain…

The chart below shows the emerging markets revival from 2009 back to its previous highs.

Emerging market stocks contain companies that pay dividends. So the main aim of the post-2008 carry trade was to borrow cheaply in US dollars and gain a healthy dividend in emerging market stocks. As long as the exchange was broadly stable, this was a solid trade.

As you can see from the chart though, the emerging market index failed to break out to new highs after rallying strongly in 2009-10. That’s a warning sign. With US dollar strength now putting pressure on the carry trade, my guess is that prices will soon break down and eventually challenge the lows reached in 2008.

If you look at the chart of the benchmark CRB commodity index below, you’ll see that commodities (in a broad sense) didn’t get much of a benefit from the post-2008 carry trade. Well, they did from 2008 to 2011 (on the back of a healthy demand story from China). But then it all went pear-shaped.

Now, commodities are the biggest loser from the recent US dollar strength. The strong dollar hasn’t hit emerging markets yet, but my guess is that it will in the months to come.

Thanks to this nascent US dollar bull market, the global carry trade is in the process of unwinding. It will cause carnage in parts of the market you don’t even know about. As I mentioned last week, it will eventually take down the yuan/US dollar peg, which will no doubt have some interesting consequences for global markets.

That’s why it’s so important to get your head around this and understand what it could do to investment markets. If you’re bearish on the US dollar, think again. The charts are telling you you’re wrong.

If you’re interested in this type of analysis (and the stock recommendations that go with it), you can take out a trial subscription, here.

Regards,

Greg Canavan for The Daily Reckoning