Why The ‘Current Account’ is Dragging the US Dollar Down

Yesterday I mentioned that gold appeared set for a potential bull run.

The other side of the gold coin is the US dollar, the unit of account that an ounce of gold is measured in.

Therefore, if gold rises in terms of US dollars, it means that the US dollar is getting weaker.

As you can see in the chart below, the US dollar index, which measures the value of the greenback against other fiat currencies like the euro, the yen and the pound, has fallen significantly since peaking in early 2017.

US dollar index has fallen significantly since peaking in early 2017 - 30-01-2018


Source: Optuma
[Click to enlarge]

At the start of this year, the index broke below long term support. While a short term rally should not come as a surprise (given the speed of the preceding fall) it looks as though the US dollar might be headed much, much lower.

So what’s going on with the US dollar?

An article in today’s Wall Street Journal attempts an answer…

American companies seem to be heeding Donald Trump’s sales pitch—they are rushing to announce investments in the U.S. thanks to tax cuts and deregulation. Yet the dollar is having its worst 12 months since 2011, giving back half the gains it made since it began to soar three years ago.

What’s going on?

The explanation for the weak dollar is both ludicrously simple and deeply puzzling. The simple explanation is that the economies in the rest of the world are finally growing again, so their currencies are strengthening. The U.S. economy isn’t improving as fast—because it was stronger to start with—so the dollar’s falling.

The puzzle is that other markets, particularly bonds, aren’t telling the same story. Bond investors, anticipating more Federal Reserve increases, have pushed the two-year U.S. Treasury yield above 2% for the first time since just after Lehman Brothers collapsed in September 2008.

That should draw more investors to the dollar, especially compared with the low-yield euro. Yet the dollar is plummeting against the euro, even while the extra reward for a two-year investment in U.S. bonds compared with those of Germany has soared.

There are several proposed solutions to the puzzle, but none is really satisfactory.

The author then went on to propose a number of theories about why the dollar was weak…which mostly involved central banks. But as he said, none of these answers were satisfactory.

What he neglected to mention was a macroeconomic statistic that no one seems to care about anymore: the ‘current account’. 

The current account is basically a measure of capital flows into and out of an economy. A current account deficit signifies a capital outflow and a surplus represents an inflow.

This is a very basic description, but you get the point.

Then there is the capital account that mirrors the balance on the current account. In theory, if a country has a current account deficit of $100 million, it will also have a capital account surplus of $100 million. Everything has to balance.

In practice, the balancing mechanism of these flows is the value of the unit they are measured in — a nations’ currency.

So if the $100 million deficit country is having trouble attracting inflows to fund that deficit, the value of its currency must fall to attract those inflows.

Let’s take a look at the situation in the US…

While the final numbers aren’t out yet, the US is on track to record a current account deficit for 2017 of around US$450 billion. In a historical context, that’s not too bad.

But with Trump’s tax cuts now in effect, US capital outflows will increase significantly this year and beyond.

The Federal government deficit is projected to reach US$800 billion this year, with some forecasts putting it as high as US$1 trillion.

Given the stronger activity this is likely to generate, the current account deficit will probably rise above US$500 billion again in 2018.

Expect to hear more about the ‘twin deficits’ driving the dollar lower this year.

In short, that’s a big supply of US dollars. If there isn’t sufficient demand to meet this supply, the value of the dollar must fall to ensure that supply and demand match.

The Eurozone, on the other hand, has a large current account surplus. With its economy now growing again, capital is coming back into the region, pushing the value of the euro up.

The euro’s strength has played a major part in the US dollar’s weakness.  Have a look at the US dollar/euro exchange rate below.

Reason for the weakness in the US dollar is strength in the euro | US dollar/Euro exchange rate - 30-01-2018


Source: Optuma
[Click to enlarge]

In short, you’re seeing global capital flows migrate from the US to Europe. That in itself is not a reason to be bearish on US stocks. In fact, a weak US dollar is particularly bullish for US and global stocks markets.

But it is a reason to be bearish on the dollar, notwithstanding the potential for a short term rally.

I’ll write more on this tomorrow. Stay tuned…

Regards,

Greg Canavan,
Editor, Crisis & Opportunity


Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

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