Pricing in the dog days of summer for the dollar

From the INK April Top 20 Mining & Crypto Equities Report - Gold is in the spotlight as we head toward a summer showdown in Washington over the debt ceiling even as the dollar is losing its lustre as a store of value among global central banks.

Cover image of the INK April Top 20: Mel Elias

Meanwhile, the Federal Reserve is now paying the price for its botched inflation strategy as cracks start to form in the US banking system.

The general consensus on Wall Street believes the US Treasury will run out of cash sometime in July unless the debt ceiling is raised by Congress. As of this week, no progress had been made on that front. Although the Republican-controlled House of Representatives passed a resolution lifting the debt ceiling, it contained spending reductions that were unacceptable to both the White House and the Senate which is controlled by the Democrats. That sets the stage for a 2011-like summer showdown between the House GOP and the Biden Administration.

There is a common assumption among many equity market investors that a deal will eventually get done to avoid a default because it is in every politician's interest to do so. Therefore, the entire process can be ignored. We believe that view is a miscalculation. There are 21 hardcore members of the fiscally conservative Freedom Caucus (FC) in the GOP and it would only take five to veto a compromise deal between Speaker Kevin McCarthy and the Biden Administration.

Wall Street analysts dismissing the chances of a default assume that there are not five GOP FC members who feel their political careers would be enhanced by pushing the system over the edge, even for a short period. We shall see. While the base case remains for some sort of a deal before a default, the chances of the process going into a default situation are not zero. If they were, the 1-month Treasury bill yield would not be trading below the overnight rate and three-month yield like it has been doing in the past few weeks.

Moreover, a default does not necessarily have to involve a default on Treasurys. The GOP hardliners could instead push the Biden Administration into having to administer a selective default where some government employees or suppliers would not be paid. Ultimately, we expect political polling will shape the outcome. If it becomes clear to both the White House and the FC that there is no political advantage to allowing a selective default, we expect a deal will be done to avoid any type of default, albeit with political drama.

However, that will not leave the dollar out of the woods. As reported by the Bank for International Settlements in its Quarterly Review from Q4 last year, the dollar has been losing market share as a reserve asset with global central banks (see chart). While the dollar's role in inter-bank trading remains unchallenged, its slide as a central bank store of value combined with growing calls from countries like Brazil for settling goods and services trades in local currencies means some marginal buyers are finding alternatives such as gold. For example, there are reports that China is developing a system to back local currency payments for oil with gold (See Renminbi internationalisation, BNP Paribas Asset Management).

Finally, the Federal Reserve is widely expected to raise interest rates again in May, a prospect that has some dollar bulls excited. Unfortunately, the central bank is now finding it is constrained by its banking system where some banks are incurring losses on the Treasury and agency assets as interest rates go up. This led to two bank failures in March (Silicon Valley Bank and Signature Bank). Further tightening runs the risk of even more bank stress. If the Fed does hike one more time, it could be the last time it is able to do so, regardless of the inflation trend. That does not sound like a tailwind for the dollar to us.

With the forces of the debt ceiling, reserve currency market share loss, and banking woes working against the dollar, gold should be a beneficiary. As such, it is not a surprise to see gold stocks dominate our Top 20 list this month.

It remains to be seen if Bitcoin, other cryptocurrencies, and crypto-related equities could also benefit as alternatives or hedges to dollar exposure. Bitcoin has been holding its own recently and all five of our top-ranked crypto-equities have mostly sunny or sunny outlooks this month.

Canadian Insider Club members can read the full report and our top 20 list here. INK Research members click here. If you are not a Canadian Insider Club Ultra member, join us today for report access.