Exploring The "Dollar Crash" Thesis

 | Jan 22, 2018 01:14AM ET

People have been predicting a crash in the US dollar for something like forever. Let's investigate another crash thesis.

ZeroHedge reports the "World's Most Bearish Hedge Fund" has a "Stunning" Theory What Happens Next to the Dollar.

Bear in mind the views that follow are not that of ZeroHedge but rather that of Horseman Global CIO Russell Clark who went 100% short in 2016 with negative results.

Clark did make money in 2017, an impressive result given the performance of the major indexes.

Clark's Theory

  • It is very easy to get bearish on bonds. With Chinese growth improving, and commodity prices rising, inflationary pressure is building. Furthermore, Chinese bonds currently offer 4%, substantially higher than developed market bonds. In addition, in a break with the Japanese experience of QE, the Federal Reserve has managed 5 interest rate increases, rather than only the one or two that Japan has been able to achieve since the bursting of the bubble. The refrain that I have heard these days is that QE works, and the US will be able to easily exit QE policies, followed by the ECB and the BOJ, and that bonds are a sell.
  • The big increase in QE from the ECB and the BOJ that we saw in 2016, has seen capital move from Japan and Europe to the US. This has meant that even as the US has raised rates, credit conditions have remained very favourable. This combined with a recovery in China has created an extremely favourable market for all assets in 2017. But what does it mean for 2018?
  • Well, if the QE model still holds, then the capital flows from Europe and Japan to the US are beginning to slow and even reverse. The implications of this is that the strategy is to be bearish US dollars and bearish on US corporate credit. It also implies being bearish on European and Japanese banks, and buying of bunds and JGBs, however this remains to be seen.
  • The worst-case scenario would be profound dollar weakness forcing the Federal Reserve to increase interest rates much more quickly than expected. Dollar weakness would cause Japanese and European exporters to suffer, forcing money into JGBs and bunds. This would be like the capital flight market in the US we saw in the late ‘70s. For reference, Swiss bonds yielded only 2% in the late 1970s, even as US rates went to near 20%.

In a nutshell, profound dollar weakness will cause the Fed to hike causing capital flight and huge rate hikes.

Let's explore the concept with pictures.

US Dollar Index vs. Fed Funds Rate