Thoughts on the Buck’s Bull Market

The greenback is on the march higher.

Last Friday, the U.S. Dollar Index (which tracks the greenback against a basket of major trading partners’ currencies, including the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc) leapt to a four-year high.

The Dollar Index has spiked over 7% in just the third quarter alone. Just look at how the closely related PowerShares DB US Dollar Bullish ETF (UUP) — an exchange-traded fund that tracks the Deutsche Bank Long US Dollar Futures index — has performed over the past three months.

The dollar’s move has been particularly strong against the euro, as well as against the yen. The greenback now is at a six-year high vs. Japan’s once-mighty currency.

To put things in perspective on just how strong the buck’s boom has been, consider that the recent rise over the past 11 weeks represents a record-setting performance not seen since the era of floating currencies began in the early 1970s.

What’s Driving the Dollar’s Run?

At the heart of the greenback’s record-setting move is a confluence of dollar-bullish factors that have made the buck the preferred choice of currency traders around the globe.

The first and perhaps most important component fueling the dollar’s latest run is solid economic growth in the United States. During the second quarter, gross domestic product (GDP) grew by an annualized rate of 4.6%. That’s a huge turnaround from the contraction of more than 2% during Q1.

While most economists don’t think the United States can keep up that 4%-plus growth pace in Q3, the consensus estimate is for GDP growth north of 3%. We’ll find out at the end of the month just what the actual GDP figure comes in at, as the print is due to be released on Oct. 30. Yet no matter how you look at things, the facts on the ground are that the U.S. economy is improving, and that is a serious tailwind for the U.S. dollar.

The economic growth driving the dollar also has allowed the U.S. trade balance to improve. The U.S. trade deficit now is only 2.3% after the current account deficit decreased in Q2 to $98.5 billion from $102.1 billion in Q1. By comparison, a decade ago the United States was running trade deficits in the 5% range.

Another major factor contributing to the dollar’s strength is the dismal state of the European economy. Not only are the euro-zone nations stagnating economically, European Union member nations are worried that the region could slide into Japan-style deflation.

Thanks to weeks of disappointing economic data from the region, any kind of interest rate increase is likely years down the road. In fact, the European Central Bank (ECB) is expected to begin its own version of quantitative easing (QE) soon. That’s a stark contrast to the U.S. Federal Reserve winding down QE by the end of this month.

Given the ECB/Federal Reserve divergence on policy, is it any wonder why the euro lost nearly 4% against the dollar in September?

According to analysts at Morgan Stanley, the euro’s fall will continue. The bank now expects the value of the euro to fall to $1.15 by the end of next year, or about 10% below its current dollar value.

Don’t Be Too Dollar Bullish

Given the latest surge in the value of the greenback vs. rival currencies, it doesn’t surprise me that the investment world has jumped on the bullish buck bandwagon.

HSBC recently argued that the greenback should reign supreme as the world’s strongest currency both this year and through 2015. HSBC even suggests a 20% rise in the dollar is a distinct possibility. Analysts at ING agree, and they’ve come out publicly to proclaim the dollar has another two years of upside ahead of it.

When the likes of Morgan Stanley, HSBC, ING and many other analysts all agree on a particular outcome, well, that’s when I start to worry.

It is during times of widespread consensus that my contrarian radar begins to sound off. More often than not, it’s when an investment theme hits the headlines that the market does an about face and makes fools out of even the wisest men.

That said, the one catalyst that is always going to push the greenback higher is the current risk aversion in many global financial markets.

A continuation of the flight from risky assets such as we’ve seen during the past month will remain the dollar’s ace in the hole. So, if the wider equity markets continue to falter the way they have in September and early October, the flight to the U.S. dollar will continue.

That also means you’ll want to avoid sectors such as commodities, gold, multi-nationals and other asset classes that tend to stumble as the greenback continues to rally.

In case you missed it, I encourage you to read my e-letter column from last week about how you can follow Harvard’s investment strategy. I also invite you to comment in the space provided below.