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Saturday, October 9, 2010

Case for a Strong US dollar

Guest post from John Chinnock

I wanted to examine something that is a very popular conception now, not only on Wall Street, but in the minds of the general population as well. Everyone I talk to or read about thinks that the U.S. dollar is doomed. From people you run into in daily life, to friends in dinner conversations, all the way up to top fund managers, it seems that everyone is on board with the thinking that the U.S. dollar is going to go straight into the abyss.

The arguments for this thesis are sound. We have printed trillions that we likely cannot pay back. If more economically troubling times are ahead, then our government will only print more in an effort to do anything possible to fend off deflation and a collapse in housing prices. Furthermore, if the U.S. prints and cheapens the dollar, this lessens the burden of repaying the trillions in Treasury debt that eventually need to be repaid. These arguments are sound and valid.

The problem is when so many people think the same way in the investing world, things rarely go as planned. What could everyone be missing? Is there a scenario where the dollar will do well? I'm not just talking about a six month rally or a short-term blip. Is it possible that the dollar could enter a long-term bull market here and surprise everyone on the planet?

Before I give my reasons, I want to fully state that all scenarios are possible here. I'm not in the camp that the U.S. dollar is necessarily going to enter a long-term bull market here. I'm just stating that there are forces that could cause this that nobody is considering.

1 - The top tax bracket is in the high 30's in terms of %. Historically, this is very low. In fact, there have been times when it was 90%! If taxes overall move higher, especially on the mega-wealthy, the dollar will strengthen considerably as the U.S. raises more money.

2 - There is a small but growing segment of politicians who want to do the right thing in terms of the deficit. Chris Christie is the best example of an extreme budget deficit fighter, but there are more and more slowly appearing in Congress with every election. This could eventually be a huge shift if it gains traction.

3 - What if the massive bailouts and subsequent money printing represented the absolute peak of government insanity? If the government even very slowly begins to shift to a mindframe of spending responsibly, the dollar will quickly strengthen. Look at it this way, they are already doing everything they can to kill the dollar, yet it is hanging in there. In terms of the pendulum, they are already nearly at a swing peak on one side. However, if they were to shift focus to repaying the debt and balancing the budget, the pendulum could swing a long long way in the other direction. This would be extremely supportive of the dollar and could cause violent moves to the upside.

4 - I have mentioned this before, but I will repeat: what would the dollar collapse vs.? The euro: they have Greece, Ireland, Portugal, Italy, and Spain all barely on life support and needing full funding from Germany and France. The yuan: China is so hyper-inflated and overbuilt that if they float their currency, it could surprise 100% of the world's economists and collapse (perhaps after a brief spike higher). The yen: Japan is in the same situation as us but far deeper in terms of debt to GDP ratios. They also suffer from an aging population and shrinking workforce just as we do, yet again there problem is more severe. The yen faces deep structural problems down the road, as does the euro as well as the yuan. All of this is very dollar supportive.

5 - My last point is on sentiment. True bull markets are born from situations where absolutely nobody believes. As the asset moves higher, everyone remains skeptical, sometimes even more so! Despite all of the dollar bashing, it has slowly moved higher over the last two years. Thus far, it has made higher highs and higher lows, while sentiment and predictions for its future have drastically worsened. I'm not stating that this necessarily means the dollar will enter a bull market, but this is perfect classic bull market behavior. Imagine how far the dollar could swing if the fund managers of the world even begin to think in the other direction and feel that a bull move might be coming.

Murf often refers to me as the dollar bull. I embrace that label, not because I feel that the dollar will necessarily move higher, but rather because I feel there are a number of potential catalysts for this move that nobody is considering.

On a final note, I do basically agree with Murf about gold. However, I don't feel that gold will move higher due to inflation. Gold will move higher due to increased stress in the worldwide banking system that will likely take years more to play out. An environment that is filled with potential debt defaults worldwide is an excellent environment for gold. Of course, an environment that is dealing with debt default worldwide is not in the least bit inflationary in any way, at least not in terms of expansion of lending and credit.

Best of luck to everyone out there,

John Chinnock

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