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The Dollar Also Rises

08/04/04 03:50:23 PM PST
by David Penn

What do debt and the short squeeze have to do with the possibility of an advancing greenback? Over the next several months, the answer might be: everything.

By one reading, a nine-month chart of the US dollar futures contract points to the beginning of a significant bull market. A major low was made in February 2004; a strong rally emerged over the next three months, only to be followed by a correction that stopped short of retracing the entirety of the previous advance. In many scenarios, this is an ideal condition for a bull. However, because this market is the US dollar, it appears as if bulls have been slower to adopt the greenback. This is a reasonable response: Cash pays very little in the way of interest (real interest rates are actually negative for cash), inflation fears are widespread (if neither deep nor readily observable in the gold price), and a host of economic and trade factors all conspire toward the image of the dollar as worse than a waste of time as an investment.

Add to this a convincing technical portrait that has the dollar at the lower end of a long-term, downwardly cast trend channel, a channel that extends back to the spring 2002 highs near 120 (the index was last at about 90), and what you have is an asset dying for love from investors and traders alike.

Nevertheless, the dollar has been moving higher in 2004, so much so that observers have noted that the dollar is the leading asset class — more so than stocks, bonds, gold, or the euro — this year. So is something in particular driving the dollar higher — or is this just a case of the dollar being down so long it only appears to be looking up?

A number of outside-the-box market analysts have come upon a unique explanation of the dollar's strength in 2004. Their theory, which combines the problems of runaway debt and credit growth with the market phenomenon known as a short squeeze, does more to explain the current — and, possibly, coming — strength of the dollar than any other I've yet come across. And should the deflation that many of the "dollar short squeeze" proponents suggest come to pass, it will be these first few months of a rising dollar that we will return to, that bull market in the dollar back in the spring of 2004, that nobody wanted to believe until it was too late.

The Dollar's Doings

I have been writing about the bullish prospects for the dollar for long enough to be right, wrong, and mostly, early (in at least eight separate articles for Working Money since "Driving Miss Dollar" in June 2002). My argument has been consistent: The dollar is headed for a short-to-intermediate bounce that will catch economists and investors off their guard. While the dollar's long-term prospects are dismal, this bounce will be significant enough to cause major pain to precious metals investors, heavily indebted borrowers, and others exposed to major dollar (or "anti-dollar") risk.

Elsewhere I have provided potential Elliott wave counts that point to the dollar moving higher. And at this juncture, whether or not an analyst believes the dollar will make a three-wave corrective move higher or a five-wave impulsive move higher based on recent action (or, more important, based on the inability of the dollar to take out its February lows), the likelihood for higher prices in the near term is significant.

A three-wave corrective move from the February lows might be expected to end with a test of the 100 level. A five-wave impulse move from the February lows could be expected to climb to 104 or higher. Briefly, the target in the three-wave instance was derived by adding the length of the previous two waves (February lows to May highs and May highs to July lows) to the value at the low of the second of the two waves. In this case, we have (approximately) a seven-point wave up added to a six-point wave down for a total of 13, which is added to the value of the July lows, about 87.

The target in the event of a five-wave impulse move is derived from a method I have presented frequently in Working Money and Advantage. This method is the one outlined by Robert Fischer in his book Fibonacci Applications And Strategies For Traders. It calls for multiplying the size of a first wave by 1.618 to arrive at a target point for the end of the fifth wave (I write "a" target point because the method seems to work more accurately with measurements taken from both the first wave and the third wave). This number is then added to the value at the end of wave one. So here, seven times 1.618 produces 11.3, which, added to the value at the top of wave 1 (approximately 93), gives a sum and upside target of about 104.

A rally to 100 in the dollar would take prices back up to levels they enjoyed back in September 2003. A rally to 104 or more would send the dollar back to levels it hasn't seen since September 2002.

Why all this attention to the upside? In part because of the technicals that suggest a move higher of some degree, but also because the honestly bearish case for the dollar — at levels that are comparable to the lowest levels in the history of the US Dollar Index — is truly bearish. Consider these observations of Tim Wood, editor of and one of the top cyclical analysis technicians around:

The dollar is at a most interesting juncture . . . Let me say this: there is a four-year, dominant, long-term cycle in the dollar. Going back to the inception of the dollar index, every time that four-year cycle has bottomed — which it did in February — every time that four-year cycle has bottomed we have seen the dollar hold up for at least one seasonal cycle. And one seasonal cycle, it averages about 12 months . . .

So, based on that expectation, we should see the dollar hold for at least the duration of the seasonal and into probably early next year, then set up with some sort of failure and then go on its way down . . .

But if we were to break here, and we could . . . take out those February lows then what that would mean is that we [would] have seen an unprecedented cyclical event . . . it would be incredibly bearish . . . If we base the expectations on the norms, then it tells me that, no, we should be moving into a low here now, we should hold up at least until next year. But if we break those numbers then, good grief, look out below.

Borrowing and Bearish Bets

But what is the mechanism — particularly in the rising dollar scenario that some (including me) are seeing — that will bring this about? One of the most interesting essays I've read this year comes from authors George J. Paulos and Sol Palha, and is called "A Day Late And A Dollar Short." I was introduced to this piece by another piece, one by analyst Rick Ackerman, that effectively summed up the argument of Paulos and Palha, as well as whetting my appetite for more analysis and discussion.

Figure 1: Should the dollar remain above its February lows, then a test of the May highs seems all but assured.

First, here's Ackerman:

Is the dollar susceptible to a short squeeze? . . . My original premise was that, in a global financial crisis, short-term lenders would not let debts roll over — that they would demand that borrowers settle up immediately in cash. Facing liquidation as an alternative, the borrowers would try desperately to get the money from somewhere. That in turn would send dollar lending rates — and therefore the relative value of the dollar — instantly skyward.

Paulos and Palha's take is somewhat different, as Ackerman acknowledges. In their scenario, an almost stealth demand for dollars begins first, a stealth demand that swiftly degrades into a short squeeze. These authors target debt as well, in particular consumer debt taken on for installment-type loans. As consumers retrench, they stop borrowing and start paying off debt.

This retirement of debt — not altogether unlike the "Rubinomics" of the late 1990s, which saw federal debtholders get paid off, the federal deficits shrink dramatically, and a sort of benign deflation from 1996 to 2000 take hold — and its attendant demand for dollars is what would provide support for the dollar. (One last note on Rubinomics, a reference to Robert Rubin's term as US Treasury secretary: Note how the dollar behaved from 1996 to 2000. It was the greatest bull market in the value of the dollar since the 1982-86 period, during which the dollar index rallied from 85 to 165.)

But how exactly does the idea of a short squeeze factor into all of this? For that, we go to Paulos and Palha:

We feel that the extreme level of US dollar-denominated debt is at an inflection point. Dollar debt is functionally similar to a dollar short position. Those who have borrowed money to exchange for another asset with the belief that the other asset will appreciate in dollar value have taken out the equivalent of a short sale of the dollar. Massive short sales have characteristics and consequences in markets, and these characteristics follow patterns. If the US dollar follows these same patterns, then there is a crisis dead ahead.

Let's recap. To borrow a dollar, to establish dollar-denominated debt, is the functional equivalent of taking out a short position on the dollar. To take a short position is to borrow a good (a stock, a currency, a commodity) with the goal of repaying that good after its value has depreciated. This is a common practice in the financial field to take advantage of a perception that prices tomorrow will be lower than prices today. Often, when prices do move significantly lower, going short can be a profitable strategy, indeed.

However, it happens from time to time that the good in question does not move lower in price and instead moves higher. This presents an initial problem for the short-seller. Now, the short-seller must consider buying the borrowed good on the open market — a good that is now more valuable than when it was initially borrowed. Because values can theoretically rise to near-infinite levels, short-sellers often move quickly to buy back the borrowed good. After all, who knows just how far against the short-seller the position might move? A buyer knows that the worst-case scenario is zero. But for a short-seller, there are no such assurances whatsoever.

As you might imagine, this presents an interesting conundrum. In buying the borrowed good on the open market, the short-seller "covering" his or her position actually contributes to the good's price rising even further. Other short-sellers, who might have been willing to ride out a small loss, are faced with increasingly higher prices — if for no other reason than the defections from the short-selling camp. As these short-sellers themselves defect, buying back the borrowed goods and driving prices still higher, they cause headaches for all other short-sellers who haven't yet switched sides.

There are even more potential pitfalls for the short-seller. Often, because the short-seller borrowed the good in the first place, a short-seller — especially those who wait longer and longer to cover their short positions — will find him- or herself unable to find a sufficient amount of the good — or at prices that are nothing but exorbitant. But pay exorbitant prices the short-seller must, or risk paying even higher prices down the road.

This set of circumstances more or less encompasses both shorting and the risk of the short squeeze, the latter referring to this phenomenon of short-sellers all trying to get out of their short positions in a hurry, driving prices up and making the experience all the more painful and costly to those short-sellers involved.

Squeezing the greenback

It is worth mentioning, as Ackerman — a former pit trader — points out, that completely worthless stocks — just the kind of stocks that traders are often tempted to short-sell — can sometimes see their share price rocket higher for no other reason than a short squeeze. As he writes:

. . . When we consider equity shares, questions of "value" do not enter into the short-squeeze dynamic . . . the short-squeeze itself is purely a creature of precipitously urgent demand — of panic, that is.

This is a key point in responding to the initial criticism that the dollar has lost much value over the past few years (real critics go back to the early part of the 20th century to suggest that the dollar has actually lost closer to 90% of its real value) and is likely to lose more. That makes the idea of a stronger dollar somewhat absurd on the face of it. "Everybody wants a weaker dollar," goes a popular refrain. What is not usually said, but is obviously implied, is "What everybody wants, everybody gets."

Of course, in the markets we realize that what everybody wants is, sooner or later, exactly not what everybody gets. In fact, market history reminds us that the opposite is as likely to occur. Interest rates began falling in the early 1980s just when people thought they would never stop rising. The same can be said of the Nikkei in Japan at the end of the 1980s, or the Nasdaq at the end of the 1990s.

So how does the squeeze happen? As Paulos and Palha point out, the scarcity of the borrowed good is what controls the intensity of the short squeeze. The harder the borrowed good is to obtain, or the more short-sellers must pay to obtain it, the higher the price of the good and the bigger the losses for short-sellers. Add to this renewed interest on the part of some bottom-fishing, extreme-value bulls, and it is easy to see how demand for such a good could skyrocket (taking the price along for the ride).

Figure 2: At the end of a long downtrend? How much further can dollar bears — and overindebted borrowers — expect the dollar to fall?

In the case of the dollar, as critics of the dollar short-squeeze thesis (as well as Paulos and Palha themselves) note, the existence of a fractional reserve banking system that is capable of creating money out of thin air makes the scarcity problem of a dollar short squeeze questionable. After all, say these critics, Federal Reserve governor Ben Bernanke all but suggested hauling out the printing press to avoid a deflation or credit crunch. Who are we not to believe him? Governments will always inflate their way out of trouble. It worked for Richard Nixon in 1972 and it worked for George W. Bush in 2003 . . .

However, while it is true that the differences over the notion of scarcity make equity short squeezes different from a potential dollar short squeeze, that doesn't necessarily make the threat of a dollar short squeeze any less. In fact, because of the differences between the equities-economy and debt-economy relationships, there is an argument that a dollar short squeeze could be far more problematic that its equity-oriented cousin. Again, Paulos and Palha:

When a broker lends stock to a short seller, the broker (lender) is under total control of the transaction. The broker has possession of the stock and the cash collateral. If the short sale goes bad, the broker has the authority to close the transaction to prevent losses to the lender. The lender of a short sale asset is almost always able to collect from the borrower so is in a particularly strong position to recover assets. Troubles with short sellers almost never cause any systemic risk to the markets.

In the case of the cash loan, however, the lender has very little control over the progress of the loan. The lender rarely has possession of the collateral and must rely on the trustworthiness of the borrower to make good the loan. If the loan does go bad, then the lender must proceed through an expensive and time-consuming collection process that may include the sale of relatively illiquid collateral. In the case of the cash loan, the lender is at a distinctly weak position to collect from a troubled borrower. Because of the inherently weak position of cash lenders, widespread defaults on cash loans can cause systemic risks to the whole economy.

Debt and deflation

Again, let's sum up the argument. Large levels of US dollar-denominated debt represent — effectively — a massive short position in the dollar. Understanding the dynamics of short positions, we see the danger lies in the unwinding of these short positions. This "unwinding" is either voluntary surrender of assets for dollars, or the forcible liquidation of assets for dollars. In either case, because the debt is denominated in dollars, it must be repaid in dollars. Not in stock, not in bonds, not in houses, not in SUVs, not in gold bullion, but in dollars.

This demand for dollars as a result of voluntary or forcible liquidation will cause a rise in the value of the dollar relative to those other goods that are exchanged for them. And, again, as we've discussed, the rising value of the borrowed good (in this case, dollars) will make it all the more painful for others who haven't yet voluntarily or forcibly liquidated — but feel that they must — to do so.

But why does anybody have to worry about liquidating anything? As critics of the debt-critics have suggested, we've been hearing about the ever-imminent "collapse of the consumer" due to overindebtedness for decades. Such indebtedness may not be healthy, these critics observe, but you can't deny the glow in the faces of the patients. And this is true enough; the history of debt is largely the history of huge amounts amassed and huge amounts paid off — though the lion's share of this "paying off" has typically occurred by way of inflation, so borrowed dollars cost less to acquire and replace than did the original ones.

So how does the liquidation — even the voluntary liquidation of assets in exchange for cash to retire debt begin? Clearly, some crisis, some cataclysmic event featured on newspaper headlines in 200-point type, would be the kind of thing that would cause the kind of major shift from pursuing and encouraging indebtedness to as the Depression-era refrain borrowed from Shakespeare went — "neither a borrower nor a lender be . . ."

Elliott wave theorist Robert Prechter, who has written perceptively on the subject of credit and deflation, suggests that if we are waiting for a headline announcement, we might be waiting for a long time:

The psychological aspect of deflation and depression cannot be overstated. When the social mood trend changes from optimism to pessimism, creditors, debtors, producers and consumers change their primary orientation from expansion to conservation. As creditors become more conservative, they slow their lending. As debtors and potential debtors become more conservative, they borrow less or not at all. As producers become more conservative, they reduce expansion plans. As consumers become more conservative, they save more and spend less . . . These forces reverse the former trend.

This is the vicious cycle of deflation as it takes hold psychologically. The products of this increasingly anxious, increasingly fearful psychology are chronicled by Prechter as follows:

When the [debt] burden becomes too great for the economy to support and the trend reverses, reductions in lending, spending and production cause debtors to earn less money with which to pay off their debts, so defaults rise. Default and fear of default exacerbate the new trend in psychology, which in turn causes creditors to reduce lending further. A downward 'spiral' begins, feeding on pessimism just as the previous boom fed on optimism. The resulting cascade of debt liquidation is a deflationary crash. Debts are retired by paying them off, 'restructuring' or default. In the first case, no value is lost; in the second, some value; in the third, all value. In desperately trying to raise cash to pay off loans, borrowers bring all kinds of assets to market, including stocks, bonds, commodities and real estate, causing their prices to plummet. The process ends only after the supply of credit falls to a level at which it is collateralized acceptably to the surviving creditors.

What is wonderful from the position of the technical analyst is the ability to anticipate these trends by way of analysis of things such as the gold price and the dollar index. These trends, as the socionomists remind us, represent not just changes in the value of a given good or medium of exchange, but also larger changes that may have a dramatic and unexpected effect on the economy and society itself. For the history of debt is also the history of ruin — for individuals as well as for corporations, for nations as well as ideals.

As the great Austrian economist and historian Hans Sennholz — who is not a proponent of the dollar short squeeze thesis — wrote recently:

Our debt generation is a sad generation misguided by false notions and doctrines, preoccupied with its own needs and wants. When economic conditions begin to deteriorate it may grow ever more egocentric and wretched, which tends to aggravate the social tension and strife. Clinging tenaciously to its transfer claims and rights, the unhappy society thus may deteriorate into a militant assembly of diverse pressure groups feuding and fighting each other.

When the political conflict finally explodes into violence, the transfer society urgently needs a peacemaker who is prepared to suppress violence with superior violence. In the end, a society that can no longer work together in peace must submit to the dictates of a strong president armed with an array of emergency powers. In other places, at other times, he would be called Caesar.

David Penn may be reached at

Suggested reading

Ackerman, Rick [2004]. "Could Short Squeeze Send Dollar Soaring?" April 23.
Blumen, Robert [2004]. "Inflation, Deflation And The 'Dollar Short,'" May 28.
Hoye, Bob [2004]. "Inflation, Disinflation and Deflation," June 4.
Hultberg, Nelson [2004]. "The Cassandras And The Optimists," May 10.
Paulos, George J., and Sol Palha [2004]. "A Day Late And A Dollar Short," FinancialSense Contrarian Round Table: April 15.
Prechter, Robert [2002]. Conquer The Crash, John Wiley & Sons.
_____ [2004]. "Deflation Has Arrived," January 30.
Sennholz, Hans F. [2003]. "Deep In Debt, Caught In A Net," October 31.
Temple, Chris [2004]. "Cash Might Not Be Such Trash After All," March 11.
Willie, Jim [2004]. "On The US Dollar Squeeze Thesis," May 17.
Wood, Tim [2004]. "Interview With Jim Puplava," July 10.

Charts courtesy of Prophet Financials Systems and

Current and past articles from Working Money, The Investors' Magazine, can be found at

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine,, and Advantage.

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