Weekly Wrap – the deflation issue

In the space of a day or so, the market’s outlook for the dolar has turned completely around.  It has been hammered in recent months as sentiment gathered bearish pace.  The story was that the dollar was doomed.  The reasons were widely-known, of course.

The US national debt was reaching for the stratosphere (Treasuries will be sold and dollars exchanged), QE has been seen as not working to aid the real economy – so many are suggesting we will see a return of it! Also, many believe (erroneously) that the Fed have been working it lower to improve US exports.  In addition, many – especially the gold bugs – believe inflation will rear its ugly head soon in the USA.

Long-time readers here know that my medium to long term outlook for the dollar is bright – very bright. This is my scenario: We are all heading for a massive deflationary collapse with Europe leading the way (OK – Japan got there first).  Already, many EZ nations are already well into a collapse of prices with the overall CPI at only 0.7% and falling fast.  This is a number keeping ECB members up at night (if they have any sense).

So much so that even Draghi last week gave a sly hint that maybe something may possibly be considered next month.  This was a bolt from the blue, as the ECB are seasoned hand-sitters and will only react when the barbarians are at the gates.

But the barbarians are now approaching the gates.  German exports are falling (high euro) and with China’s economy at a knife edge, the huge Germany – China trade will continue declining.  Also, the euro/yuan rate appears to be rising (yuan will change trend and now weaken vs the dollar), putting more pressure on German exports.  And we all know that Germany holds all the cards in the EZ.  Industry there is screaming at the ECB to do something to weaken the euro!

Since Thursday’s Draghi comments, many commentators gave their knee-jerk reaction that he said nothing new and at most, the ECB will perhaps lower its policy rate a tad, or perhaps charge interest on bank deposits to induce the banks to lend more to the real economy.  This policy is doomed to failure because the demand for loans is so weak and will not suddenly spring to life because banks are offering more loans (pushing on a string).  They will be foolish to loan against poor collateral anyway (house prices are in decline).

The strength of the euro has also been a result of PIIGS sovereign debt buying where yields of Italy debt (with a debt-to-GDP ratio off the scale) has fallen to a measly 2.95%!  Yield on Spain’s debt likewise is a paltry 2.95% in a country with over 25% unemployment. This is only a smidgen above the risk-free 10-yr Treasury!  This is an accident waiting to happen as the euro weakens.

Will ECB start a QE operation in June?

But I believe there is every chance the ECB will announce some form of QE – a policy they have steadfastly refused to contemplate because of the resistance of the hard-money stalwarts in the Bundesbank, who have the Weimar 1920s hyperinflation history in their DNA.  If your nation had seen in 1919 one loaf of bread costing 1 mark and then in 1923 it costs 100 billion marks, I’m sure you would remember that!

The ECB is in a fix, and the market is starting to wake up to that fact.  Whatever they do, they will not succeed in ramping up the EZ inflation rate to their 2% target, but that will not stop them trying.  The most radical policy (and remember they are not noted for radicalism) is to pump liquidity into the real economy, rather than the UK and US versions where they bought bonds and there was minimal impact on people’s lives (except for bankers, that is).

This means that the perception that the supply of euros will surely rocket.  And with the commercial demand for euros set to decline along with the commercial demand for dollars set to rise, the EUR/USD is on the starting blocks for a huge leap lower.

US  manufactured goods are seeing a renaissance from the weak dollar and lower costs (low energy prices and stable labour costs) – which is supporting the Dow and S&P – so we have a perfect storm for the euro.

The scramble to get into dollars will intensify, especially when US rates rise.

EUR/USD

Last week I wrote:

“It is desperately trying to rise above the 1.39 level but to me, unless it cracks on to 1.40 pretty soon, it will give up and the 1.38 support level will again be tested.

“Yesterday, the knee-jerk reaction following the non-farms data was typical – a down move and then a reversal back up – but only to my line of resistance.

“There should be a stack of buy-stops just above the 1.39 level, as this is an obvious place for shorts to bail out.  If this area is challenged next week, as appears likely, look for a reversal and this move will likely be faded.“

This forecast was on the button with the euro taking out those buy-stops above 1.39 and came within 7 pips of the 1.40 level and then began the ferocious break.  Note that the much-touted round number 1.40 level was missed.  Remember the notorious gold rally towards the $1340 level and missed it before collapsing?

The missing of targets is becoming a notable feature of markets these days – the GBP/USD also just missed its 1.70 round number target last week by mere pips.

What does the big picture look like now?

The 1.40 level is the exact Fibonacci 2/3 retrace of the big move down off the 2011 high near 1.50, and this is major resistance.  Note the weakening rally as the neg mom div has been forming since last summer.  The Fib level hit confirms the A-B-C corrective move is now over and the next big trend will be down.

What about the hourly chart?

The market has lost 2  1/2 cents in one day – a massive hit to the bulls (where DSI bullish sentiment has been running over the 80% level recently).  The first support area at 1.3780 was smashed and the next support is around 1.3660.

Rallies are to be shorted.  I remain short.  Ditto GBP/USD.

DOW

I had an extensive analysis in yesterday’s MoneyWeek Trader email.  Traditionally, US stocks and the dollar have moved in inverse fashion, and that has held true recently.  The textbook reason is that a falling dollar is inflationary (imports more expensive) and that supports stocks versus bonds.

If that relationship still holds , and if the dollar is about to gain strength, this has deflationary implications (imports getting cheaper) and bad news for stocks.

The 16,600 area is critical resistance and if it fails again, the market will test the lower wedge line and a break here will signal the start of the next leg down.

It would take a solid close above this level to put this forecast on hold.

T-BONDS

I am less inclined to favour my bullish stance now:

In a deflationary collapse, Treasuries may or may not rally – the usual contra relationship may be broken in the stampede to liquidate assets in favour of cash.  DSI bullish sentiment has risen to over 80% and it is rarely a good time to go long when the DSI is at this level.

A break of the 135 level should confirm the start of a new downtrend.  I remain neutral, pending developments.

Have a great weekend!