The Dollar is Breaking Out — and Confirming the Imperial Circle — on Manufacturing Strength
Imagine a world where the U.S. economy is freakishly strong.
Now imagine this Frankenstein-like strength is powered by trillion-dollar government budget deficits through a quadruple-whammy:
First, the trillion-dollar deficit being generated by the U.S. government is flowing into the pockets of the private sector (via government purchases of goods and services with borrowed money).
Second, private sector companies are creating more cash flow for workers via historic wage gains (think airline pilots, UPS workers, auto workers, and so on).
Third, picture interest rate payments in the hundreds of billions — because at least half the U.S. Treasury market is domestically owned, and interest rate payments are approaching the trillion-dollar mark too — generating heavy duty cash flow going into the pockets of savers who own U.S. Treasuries and money market funds.
Fourth, picture the economy's strength bolstered by cheaper-than-hash-browns natural gas (a hugely important fuel source) and a housing market with prices that refuse to adjust downward as long as the labor market remains strong.
In a world like that, the fly in the ointment is the rapidly accumulating debt on the government's balance sheet. To bring out the word "trillion" yet again, one would rationally expect adding a trillion dollars to the national debt every hundred days to be an invitation for trouble.
And yet, what if the U.S. can effectively say to the rest of the world:
"You will buy our treasuries and you'll like it."
And what if the rest of the world effectively says:
"Yes you are right, there is no economy like the juggernaut U.S. economy — most everywhere else looks "meh" if not bad or terrible — and besides, we like your rising yields and want less exposure to Europe."
This is the world of the Imperial Circle in which U.S. growth — powered by runaway deficits — is readily financed by U.S. Treasury buyers who absorb the debt expansion while strong growth absorbs the higher yields.
In this world, long-term interest rates rise but not catastrophically so. Instead they rise in proportion to U.S. economic growth, where the debt powers the growth and the growth withstands the higher financing costs in a kind of virtuous circle (or rather an Imperial Circle).
And in this world the dollar rises too — at first like a phoenix from the ashes, and then like the Incredible Hulk — because the U.S. is sucking in capital from the rest of the world, with said capital attracted by rising yields and debt-financed relative strength.
The Imperial Circle is one scenario among multiple options for explaining the current state of things in relation to a path forward. But it's a scenario that resonates strongly right now.
Put another way, the "imagine a world" picture we just painted is not hypothetical — it is playing out before our eyes.
Look at what the U.S. dollar index did today:
The dollar is breaking out, in part because U.S. Treasury yields are powering higher on strong economic data (more on that in a moment).
The U.S. Treasury 10-year yield is close to a five-month breakout from a multi-month bullish triangle, as shown below.
The economic data powering both phenomena — a rising U.S. 10-year yield and a USD breakout — is the first bullish upturn for the U.S. manufacturing sector in 16 months.
U.S. economic output can be roughly divided into goods and services. Manufacturing counts as goods — alongside other industries that produce tangible items — while most of the U.S. economy counts as services.
To track the state of manufacturing, the Institute for Supply Management (ISM) publishes the monthly ISM Manufacturing Purchasing Managers Index (PMI).
The March manufacturing PMI came in at 50.3 on a scale where anything below 50 means contraction and, conversely, anything above 50 means expansion.
This suggests that, instead of slowing down, the U.S. economy could actually be accelerating.
In the slowdown script, services activity is supposed to follow goods activity into contraction. Instead, goods activity (manufacturing) appears to be picking up.
As we have said repeatedly, in this bizarro-world situation, long-term interest rates — like the 10-year yield, the most important interest rate in the world — are key to this whole picture.
And if the U.S. economy stays strong enough for the 10-year yield to normalize (rise) in an orderly way... as the Fed stays moderately hawkish (because growth forces it to) the rest of the world continues to finance U.S. debt expansion... we get the Imperial Circle scenario in which the dollar roars.
We don't like stocks in this world because rising yields are kryptonite for inflated stock valuations — and so is a superstrong dollar.
In sum, higher yields and a ruthlessly strong dollar are coming to pop the bubble of inflated stock market expectations. There are three things that could stop this. The first is a debt crisis (a sudden loss of confidence in U.S. Treasuries), the second is a real estate crisis (either housing or commercial), and the third is a sudden sharp deterioration in the labor market.
None of those are bullish for euphoria-tinged risk assets.
Until next time,
Justice Clark Litle Chief Research Officer, TradeSmith
TradeSmith is not registered as an investment adviser and operates under the publishers' exemption of the Investment Advisers Act of 1940. The investments and strategies discussed in TradeSmith's content do not constitute personalized investment advice. Any trading or investment decisions you take are in reliance on your own analysis and judgment and not in reliance on TradeSmith. There are risks inherent in investing and past investment performance is not indicative of future results.
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