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All About the Dollar Index

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With next week's big powwow in Washington between Paulson and the Chinese drawing near, it's a good bet that at any time over the next couple weeks that the Chinese could go ahead and revalue the yuan significantly higher against the dollar.

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When most people think about the dollar, they think about the euro-heavy US dollar index (see the chart of the DXY below), which is basically just a proxy for the euro due to its 57% weighting.

The US dollar index's all-time fiat low is the 78-80 level, which it has remained above since the US went off the gold standard in 1971. However, because of how heavy the dollar index is in euros, it's not a great proxy for how the dollar is truly trading against the US' major trading partners.


Click here to enlarge.

That brings me to the Fed's trade-weighted dollar index. Note how the trade-weighted dollar index (see the chart below) has barely even bounced (unlike the euro-heavy US dollar index above) and appears to have already broken a critical area of support on the charts. It's also just a hair away from breaking its 200-month moving average, something that hasn't happened since the 1970s when the US last "defaulted" and broke from the gold standard to the current fiat dollar monetary system in place today.


Click here to enlarge.

The reason I think this may be important is because I believe the pressure on the Chinese to revalue is becoming almost too much for the PBOC to bear. And I'm not talking about US rhetoric pressure, I'm talking about market pressures.

A significant Chinese revaluation of 10 to 20 percent sends this trade-weighted dollar index dramatically lower. Remember, the index is trade-weighted, unlike the "US Dollar Index" that we all watch. Therefore, China and the rest of Asia make up nearly 40 percent of the trade-weighted index. You can see the exact weightings by country at the Fed's website. It's also a good bet that the move in gold to the upside when and if the Chinese move could be surprisingly spectacular as well.

Incidentally, the Canadian dollar is 16.5 percent of this trade-weighted index, and the Canadian dollar is up a percent to a new 30-year high today.


Click here to enlarge.

The PBOC raised its lending rate overnight by 18 bps to 6.57 percent as well as raised bank reserve requirements again. The PBOC also slightly widened the band in which the yuan is allowed to fluctuate from the prior 0.3 percent to 0.5 percent above or below the previous day's closing value. On Thursday, the Chinese also allowed the yuan to hit another new all-time high. These are all token moves, but they also show that the PBOC is struggling with the tidal wave of dollars that is hitting its shores

With next week's big powwow in Washington between Paulson and the Chinese drawing near, it's a good bet that at any time over the next couple weeks (including this weekend) that the Chinese could go ahead and revalue the yuan significantly higher against the dollar (although they're still unlikely to float it just yet).

Yesterday, China's Premier Wen said, "We face excessive liquidity, an imbalance in the balance of payments, and rapid accumulation of foreign exchange. But we are taking measures to deal with these issues," which many took as a hint that China may indeed revalue its currency significantly in the near future.

The pressure from the market on China's currency is truly enormous, and the distortions that it is causing not only in China but globally are only going to get worse the longer they drag their feet. China's foreign currency reserves surged by a record $136 bln in the first quarter to $1.2 trillion. This is simply not sustainable. With the US Congress threatening trade sanctions that the White House is indicating it may no longer be able to postpone anymore, the timing appears right for the Chinese to potentially finally say "Uncle" and move significantly. A small move will only make things worse.

If the Chinese do finally move, it's going to send US bond yields dramatically higher (where they're already heading as it is) as well as cause equity dislocations in both China and the rest of the world. This is not rocket science. An Asia Times article earlier in the week even detailed the likely consequences of a move.

Because of the negative short-term consequences for US markets and the fact that the US is the one pushing for the move, I have to believe that the Fed already has a plan in place for when the Chinese finally do move. And as Heli-Ben told Congress just a few months ago, that plan is probably to cut short-term interest rates in the US at the same time that China revalues and maybe even buy treasury bonds too in order to minimize the initial shock of the move to the bond market and the economy (although the resulting increase in inflation would probably prevent any further rate cuts).

Such an accompanying rate cut would minimize both the shock to the equity market and the US economy in the short-term, although the damage to the dollar, higher US long-term interest rates, and the higher rate of inflation that would result from a revaluation would eventually catch up with the equity market and merely make things even worse later on down the line for the already stagflationary-prone US economy.

So, this is something I want to really keep my eyes on. When and if the Chinese do finally move, the break in the dollar against the rest of the world's currencies (especially Asia) is likely to be big. Remember, the US would receive a significant overnight increase in its rate of inflation if the Chinese were to revalue due to all the manufactured goods that are imported from China and the rest of Asia, which would only further trap the Fed in the stagflationary mess that it's already in.

None of that is good for the dollar, and it could very well be that a move on the part of the Chinese is what finally sends the dollar off the proverbial cliff. The sharp rise in long-term interest rates that the US would see alone would turn what is already a housing bust into a housing depression, with very little initial benefit to US exports, which are still such a tiny portion of the US economy after so many years of contraction.

I do believe, however, that such a revaluation move would be greeted as extremely bullish for gold, not only because of the dollar's resulting decline and the overnight increase in the US rate of inflation but also because the PBOC would likely begin to accumulate gold with its excess dollar reserves in advance of an eventual full float of the yuan at a later date (and the Chinese may even be already buying gold for all we know).

That's just a lot of wild speculation until we see something happen, but given the strange moves in the short end of the yield curve over the last couple weeks (i.e. - heavy Asian and Chinese buying in three month and six month bills), comments coming out of China, the timing of next week's meeting between Paulson and the Chinese, as well as various rumors that keep going around... we could be very close to a big event like this.

If so, one needs to have a plan in place on how one is going to react before it happens, as well as recognize the signs that the market is sniffing out the fact that such a move is very close in time.
No positions in stocks mentioned.

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