US Dollar: Killer App

From the March 9, 2015 HRA Journal: Issue 229

More of the same.  The US Dollar continues to surge and mow down everything in its path.  The distortions created by these currency moves are getting large enough to be dangerous.  The potential for one or more emerging markets to get into serious trouble based on US denominated debt is quite real now.

Even Wall St which refused to view any news as negative is starting to worry.  Imported deflation won’t be enough to save profit margins for a host of multinationals if the Dollar keeps rising.  The minor—and they are minor—rate increases the Fed is considering shouldn’t matter but in a zero bound world they do.  Traders are more convinced than ever that rates will rise soon.  I’ve thought they should for over a year but Yellen needs to be very sure when she makes her move.  A policy mistake now could be expensive for everyone. 

There is little relief in sight until this situation resolves itself.  I still think we end the year with a strengthened Euro and topped out Dollar.  That would help everyone in the commodity space. If the world can achieve a more balanced growth profile—almost regardless of the actual growth rate-the markets will be a safer place.  Everything is moving to extremes so we have to be watchful.  I don’t expect a crash but a significant pullback now would only require a couple of the wrong data points.  Traders are already spooked.  Dry power and crossed fingers for those intrepid enough to be drilling.

Eric Coffin


I’m just back from the Subscriber Investment Summit and PDAC in Toronto.  The SIS went very well with good attendance and a great group of companies that gave informative presentations.  There were a lot of buy-side types on hand, local investment bankers and European fund managers.   I’m hoping that means there is new interest being shown, not that they all needed the free lunch to get through the weekend.

The PDAC was smaller than last year.   Not as large an attendance drop as I would have expected though.   This year’s number was just under 24,000 which is stunning when you consider the health of the sector.  I think that is a testament to the number of student and government delegates.  Those two categories don’t seem to fall much even when times are tough.  It’s easier when someone else is paying your expenses I guess.

It was a different story on the public company side.  There were changes to the display area that made it less obvious but there were a lot less public company booths. 100 to 200 less than previous years.  The PDAC is used to having a permanent waiting list for public companies that want to exhibit.  It looks like those days are definitely over.  There were a lot of supplier booth in the public company area and plenty of conversation areas and widened corridors set up to cover for empty booth spaces.

This state of affairs is a positive for contrarians like me and long overdue.  There was a lot of buzz about a report released by Tony Simon, a Vancouver based CA and a friend of mine.   Tony pulled no punches, stating there are 600 “zombie companies” on the Venture Exchange that have a collective working capital deficit of about $5 billion.

I don’t find that number shocking but many others did.  It got a lot of press in Canada.  I’m sure the number is pretty accurate; Tony knows a thing or two about financial statements and it largely jibes with what my colleague John Kaiser has been saying for years.

Tony’s main point wasn’t the working capital situation.  It was the fact that the Venture Exchange and the TSX allow hundreds of companies that don’t meet minimum listing requirements to stay on the board.  Again, no surprise to me.  I’ve made comments before that when the TSX moved from being a (sort of) public utility to a public company with its own profit guidance to attain, things changed.

I don’t doubt for a minute that the Exchange is going easier on companies that keep paying listing fees even if they aren’t paying anything else.  I don’t think the Exchange is being totally self-serving.  In addition to worrying about their own bottom line they are concerned about shareholders of all these companies that will be out in the cold if they get delisted.  That concerns me too but I think Tony and John are right in believing the situation simply isn’t salvageable for many of these companies.  Its better if the charade is ended.

My concern, as I have said many times, is that the $200 million or so that gets wasted on M&A expenses for these zombies would be better spent on the smaller number of good companies with good project run by good managers.  In a shrunken capital pool we don’t want to throw good money after bad.  If that means a few hundred companies—many of which are trading at a penny anyway—get the axe then so be it.

“PDAC Curse”: Right on Schedule?

Every year there is discussion about the “PDAC Curse”, the pullback in resource stocks that often follows the annual confab.   In part this happens because so many companies store up and then release news in the week leading up to PDAC. In many cases there is nothing for them to talk about after that. That leads to a letdown for resource stock traders that is later compounded by seasonal factors.

This year of course we have another culprit; the mighty greenback.  The US printed a major upside surprise when the February payroll report was released.  The US generated 295k new jobs versus a consensus estimate of 235K.  The markets went nuts after the release of this news as traders tried to price in a near term rate increase by the Fed.  Gold, equities and bonds all sold off and the US Dollar broke out of its two month trading range to the upside.

It looked like the USD might break higher even before the payroll report.  With the ECB starting its QE program plenty of currency traders were front running it by going long Dollar and short Euro.  This trade just keeps getting more one sided.  The logic is easy to understand and the trend may have a bit longer to run.

That said, as I noted last month it’s actually bee Europe that has provided most of the positive surprises when it comes to economic readings. The top chart on this page shows the Citigroup “surprise index” for the US in black and EU in red.  The index measures actual economic readings against consensus estimates.  For the past three months the EU has been beating estimates pretty consistently while the US came in below them just as commonly.

It now looks like the EU may print a 2015 growth rate in the 1.5-2.0% range.  Not awe inspiring but a big improvement over the consensus forecast only a few weeks ago.  The lower chart shows the EU trade balance and that has improved massively in the past few months thanks to cheaper oil and the cheap Euro.  Net exports go right to the growth rate in national income accounting.

Mario Draghi is already declaring victory for his QE campaign. Premature of course but in one sense he’s right.  Even before the bond buying starts its achieving some of his objectives.

Yields have continued to drop across the EU and the Euro is now below $1.10.  the currency move combined with low oil prices has been a huge boon for the EU.  I continue to believe Draghi just might finally pull it off, helping the EU get out of its eight year funk.  He certainly deserves the credit since he has had to fight EU finance ministers constantly to make it happen.

If the EU does pull out of this economic tailspin as I expect there will be room for the US/Euro exchange to rise. It’s still my expectation that we will see a stronger Euro by year end but traders need to get past the shock and awe phase of the ECB QE program and the first Fed rate increase.

As the Citigroup chart indicates many recent economic readings from the US have been lukewarm. Q4 growth was revised down to 2.1% and Q1 may not be any better unless we see some acceleration right away. Those aren’t terrible numbers but they don’t point to the ramp up in growth everyone’s hoping for.  The February payroll number was great but there were aspects of the report that indicate the need for continued caution on the part of the Fed.

Wage growth was again lackluster, to be polite. Bulls made plenty of excuses but YoY wage growth under two percent is not going to drive consumer spending.  Also perplexing to me was a small drop in the participation rate.  Fewer jobseekers entering the market when the unemployment rate is 5.5% is just weird.  I still haven’t seen a convincing explanation why this rate dropped after 2009 and stayed down.  With losses in higher wage oil and gas jobs just starting to show in the stats Fed chief Yellen would be wise to play it coy until she sees more data.

The two charts below show the damage to the gold price in the past month and rise in US bond yields through the same period.   Most were surprised by the strength of the reaction to the payroll number since no one expected a weak report.  As you can see the correlation with the USD has gone quite negative again at the worst possible time for gold. That is simply a measure of how strong the bullish bets on the USD are right now.

The lower chart shows the 10 year Treasury losing all its 2015 gains, just as gold did.  10 year yields have risen over 50 bps since the start of February.  Keep in mind that the bond market is where loan rates really get set.  The Fed funds rate is just guidance.  In effect, the market is already delivering some of the tightening the Fed has been threatening.

This is written a day after the payroll report so it’s too early to call trends in anything.  I would say there are a lot of similarities to the “taper tantrum” that occurred when the Fed first started hinting about rate increases a couple of years ago.  If that trend continues we could see some more pullback in equity markets. I’m not bearish but valuations are rich and have low rates built into them.  If bond yields keep rising a drop in share prices would be a reasonable reaction.

So far we’re talking about nominal rates.  In real (inflation adjusted) terms we may see more increases even if nominal rates don’t move much higher.  The US has seen less deflationary pressure so far but that could change now.  If the USD keeps rising the US will be importing deflation.

Other economies, especially emerging ones, are doing the opposite.  Emerging market currencies are getting hammered.  The huge fall in oil prices is masking the potential for inflation increases based on currency depreciation.  We’ll see if the oil traders or currency traders blink first.

Economies with a lot is $US denominated debt—there are several—have a much tougher  path.  Falling domestic currencies are good for exports but ballooning their debt loads.  With a currency war on, no one wants to raise interest rates to strengthen their currencies. There is plenty of room for bad outcomes from policy mistakes.

One economy with high real rates and a pegged currency is China.  China lowered its 2015 growth estimate to 7% which surprised no one.  The Bank of China has cut rates twice in the past month.  The strong export numbers it just released may lessen the chance Beijing enters the currency war.  I don’t think it wants to.  China aspires to having a global reserve currency and stability matters.

Beijing is resisting broad stimulus fearing re-igniting credit bubbles. Cutting the value of the Yuan would be easy but the US will scream about the “undervalued” Yuan if it does.  I can understand China’s leadership thinking they shouldn’t be “taking one for the team” again.  Few give China credit for its massive stimulus program in 2009 that was a major reason the world economy pulled out of its dive.  If China does move its Dollar peg lower it could hurt commodity prices but I think they will try to hold the line.

All this drama added up to gold falling back near its 2014 low.  Whether we get a bounce now may depend on physical buying.  The timing’s not perfect.  We’re on the wrong side of the Lunar New Year for heavy gift buying but price conscious consumers might be persuaded by current prices.  So far this year Chinese gold imports are up 15% but we need more weeks of data to get a comparable figure.

The case is similar but more positive in the short term in India.  This year’s government budget did not include the cut in the gold tariff traders were hoping for.  That is a negative though many feel the easing of the “80:20” rule for jewelers last year was more important.

In either case there should be an increase in demand over the next few weeks.  India’s jewelers had been holding back purchases in the hopes the tariff would be removed.  Now they will have to restock for the wedding season that still has a couple of months to run.  The premium on the local bullion price in India rose immediately after the budget was announced indicating increased demand.

I’m more positive about the EU and still constructive on the US.  This could still be a decent year but the danger of big trouble from emerging markets is high as long as the currency war continues.  The updated US crude inventory chart shows why I expect oil to have another pullback.  That is positive but keeps deflationary pressures high.  Gold is still the world’s second favorite currency but we need to see it in top spot for a few weeks to open the financing window.

Short term the PDAC Curse is in play.  The overbought Dollar and oversold Euro have to find equilibrium.  The Dollar is hurting the US economy now and driving deflation.  Wall St is getting worried about the impact of rate increases. In the greater scheme of things 50bps should make no difference.  The fact it does tells you how dependent the market is on monetary engineering.  That is not a good thing.

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