Day Late and a Dollar Short: Lessons in Timing and Consequence

by George J. Paulos of freebuck.com and
Sol Palha of tacticalinvestor.com

Catching the Wave: Day Late and a Dollar Short

Updated Jan 2023

In the spring of 2004, we published “A day late and A Dollar Short” an analysis outlining the risks of what we called a “dollar short squeeze” scenario where we envisioned a rapid but short-lived deflation caused primarily by the effects of excessive dollar-denominated debt. The article caused quite a stir and inspired many analysts to respond positively and negatively. We thank the authors who took the time to reflect on our thoughts and react to them.

Our goal was to spark a dialogue about a subject completely ignored by the mainstream press, and that goal was achieved. The “dollar short” theory has since been endorsed by Richard Russell, Bob Hoye, Rick Ackerman and others. Many other writers have taken a strongly critical view of the theory, and we respect their opinions.

The dialogue continues

Many months later, the dialogue continues, but we have noticed that our original thesis is now being misrepresented as a “deflationist” theory and primarily concerned with the US dollar’s forex (foreign exchange) value. Reviewing our work, we can understand how misunderstandings could be gleaned from such a long and complex article. We now see how we could have presented the subject more clearly. Discussions of currency value are difficult and prone to misunderstanding because of the dual role of a currency as both an asset and a benchmark of value. We take this opportunity to restate and amplify our views concerning the current situation.

Our original thesis contained the following points:

Cash in the form of US dollars is a fundamentally weak asset class. This weakness is well known to almost all market participants due to the long-standing trends of US indebtedness, current account deficits, weakening manufacturing sector, and chronic inflation.

Most investors and consumers have taken on large amounts of debt to capitalize on the belief that inflation will continue uninterrupted into the future. This massive debt load is similar but not identical to a “synthetic short” position on the dollar.

A debtor is similar to a short seller but one who is short cash rather than another asset. A debtor can be ruined if the cash value of the collateral falls below the amount owed, just as a short seller can be ruined if the cash margin falls below net asset value.

Day Late and a Dollar Short: Navigating the Pitfalls of Shorting

They often create conditions that cause weak assets to rise quickly in value in a “short squeeze” situation. These short squeezes are common in all markets that allow short selling.

Short squeezes are rapid but short-lived events that can cause investors with bearish short positions to be wiped out due to a sudden rise in the asset value as other short sellers make panic and buy back their short sales. This can happen even if their fundamental bearish opinion of the asset is correct. Short squeezes are counter-trend events.

A cash short squeeze in the US dollar would be functionally equivalent to a rapid but short-lived deflation where general prices fall in response to a sudden collapse in demand as cash and credit become temporarily scarce.

Official responses to a sudden deflation by rapidly increasing money supply would take time to implement due to administrative delay, political infighting, and the slow speed of diffusion of new money into the economy. Ultimately, reflationary policies from the central bank and other authorities would gain traction and again create the desired inflation only after much damage.

In our original analysis,

We only briefly touched on foreign exchange and how the dollar would fare in relation to other currencies. The article was already long; we did not fully analyze how such a scenario would unfold in the forex markets.

We did not imply that a short-squeeze deflation would be permanent. Our original article stated, “In the aftermath of such an event, it is quite likely that the dollar would resume its decline due to the continued deterioration of the fundamentals of the US economy. Remember, a short squeeze indicates no change in asset or security fundamentals.

It is a confirmation of its weakness. The irony of the situation is that those who are convinced that the dollar is slowly dying are probably right but their collective action makes their investment positions untenable.” In the long run, we assume that inflation will continue and may even accelerate. Our point is that inflation is not necessarily a straight line to oblivion but can take a complex course, even reversing at times.

Deflationary Shock: Catching Dollar Bears Off Guard

Although we feel that the actual event would be short-lived, damage from even a short bout of hard deflation could be deep and long-lasting, considering the huge US debt overhang. Highly leveraged investors could be wiped out even if their securities quickly recovered. Consumers who fall behind on debt payments may be unable to catch up or may find they owe more than their collateral is worth. Marginal businesses may fail if demand and pricing temporarily collapse. Faith in mainstay investments and assets would be broken.

Short Squeeze Signals: Identifying Precursors for Market Surges

Since our original essay was published, there have been no indications of dollar short squeeze phenomena. However, there have been several developments that can be interpreted as precursors to such an event:

The US Dollar appears to have put in an intermediate-term bottom on forex trading
Many commodity sectors, including metals, agriculture, and other soft goods, have fallen substantially.
Long-term US interest rates have fallen.
Many measures of inflation have fallen.
Most stock indices have fallen.
Money supply growth has stalled.
Increasing inventory in national real estate is indicting topping action in home prices.
The US consumer shows signs of fatigue, as shown by sluggish retail sales figures.

Forex Implications of a Dollar Short Squeeze

If prices temporarily fell within the US, how would the dollar fare in foreign exchange markets (forex)?

Everything has a trend, and it’s well-known that nothing will trend in one direction forever. So even though the dollar is technically shot to pieces and fundamentally rotten, it will have a strong counter-trend rally at some point. When the dollar begins to rise, these signs will start to manifest themselves.

Goods will start to drop in price. This has already begun and will keep accelerating for a while. Electronic goods, now even many agricultural products, are dropping in price. What is even more interesting is that gas prices are no longer rising even though oil keeps setting new highs almost daily.
The currencies that rallied while the dollar plunged will be topping or putting in their final highs.
Consumers will start to cut down on their spending; the latest consumer spending figures indicate that the consumer is slowly tightening his or her belt.

Derailing Synthetic Dollar Short: The Fed’s Unyielding Actions in Focus

They believe the US cannot have deflation take over under any circumstance, so they will start running the printing press at full speed. We believe the recent rate hikes were implemented to confirm the illusion that the economy is improving and that, most likely next year, the Fed might have to reverse some of the rate hikes implemented this year.

If the Feds lower rates, then investors won’t want to hold dollars because most of them are not speculators. Only speculators will then be willing to play the rise in the dollar. The Feds will most likely succeed in triggering inflation and ending these initial deflationary forces. This could backfire and bring on hyperinflation.

Harmonious Coexistence: Deflationary and Inflationary Forces in Balance

Let’s pause for a moment and delve into another aspect. Currently, there exists a delicate balance between deflationary and inflationary forces. Within the energy sector, we observe significant inflation, while the manufacturing sector experiences pronounced deflation. It’s crucial to note that deflation and inflation are cyclical phenomena.

In other words, they are nothing but trends, and when the trend breaks in one, it will trigger an uptrend in the other. For example, the Feds could trigger hyperinflation by running the printing presses into the ground due to their fear of deflation. This will force everyone to try and cut down his or her debts as soon as possible. In this case, hyperinflation could bring about a cash short squeeze because prices are rising faster than consumers can absorb.

Inflationary Impact: The Dilemma of Paying Off Debts

Well, that is the theory, at least, because the future value of your dollar keeps declining. There is one little problem, what if you have no future dollars coming in or if your future dollars are not coming in as fast as inflation is rising? In other words, what if your income is not increasing enough to pay rising bills? What if your income is declining?

We are already witnessing that in the health sector right now. A big article on Yahoo stated that insurance rates are rising at three times the levels of individual salaries. This is equivalent to a reduction in pay because health insurance premiums are deducted directly from paychecks. In such a situation, one would either look for ways to cut down one’s debt or, at the very least, try to spend less. Eventually, such spending cuts will trigger deflation as individuals seek to cut their discretionary spending out of necessary business.

John Tyler (www.trader007.com) recently had the following to say as far as the dollar goes:

The G7 have been meeting recently but have been keeping it very quiet. “I suspect they are trying to create the impression of a falling dollar so traders will be caught out”. Bush, Blair and Howard are all getting together. They are all facing a rather tight race and want low oil prices, so they will team up to pump the dollar. It fits the BIS objective for stability, which is political first and foremost so that they can continue to operate, a Darwinian survival imperative.

The Ripple Effect: Impact of a Strengthening Dollar on Other Currencies

In a way, this question is rather idiotic. We no longer have a constant to measure any currency, so everything is just arbitrary now. However, if we look at 10 years, we see that several currencies increased in value while several decreased in value. So when the dollar rises, some currencies will pull back while others might rise with it. What everyone is missing is that not one central bank will allow its currency to keep appreciating.

This is because if one currency should be allowed to get too strong, that nation will be priced out of the export markets. Since we are a global economy and interdependent on trade with each other, a powerful currency is something no nation wants at this point.

Unleashing Economic Rivalries: The Era of Competitive Currency Devaluations

This is the era when nations will start to devalue their currencies to stay competitive.

This virtually assures us that the Dollar will not be allowed to rise in value indefinitely. In some way, these moves are being engineered as the current value of the Euro is hurting the entire Eurozone and benefiting Asia and the USA tremendously. It makes our products more competitive.

So the real question is, what will happen once we enter this aggressive stage of competitive currency devaluations? Gold will finally start to shine as it enters the true bull market stage and rallies in every currency. Gold’s price is based on what the dollar is doing, but there will come a day when Gold will rally in the face of a so-called rising dollar. Those that waste too much time analyzing the rise of the dollar in terms of the forex value are missing the big picture: the slow but sure competitive currency devaluations currently taking place.

Synthetic Dollar Short: Devalue or Perish?

China has decided to take part in this by pegging the Yuan to the dollar, other Asian countries are doing this by selling their currencies and buying dollars, and the list goes on. We have not entered the fiercely competitive stage, where the theme will be “devalue or die”. Once we enter that stage, the only thing worth looking at will be Gold. Eventually, they will come out with a currency scheme that will be partially backed by Gold, a point in time representing the peak of the gold bull market.

“Resonating Perspectives: Marc Faber Aligns with Our View”

“I should also like to mention that if this scenario of a weak economy does come into play, the dollar could surprise on the upside simultaneously with the bond market. Why? Because weakness in U.S. consumption will improve the U.S. current account deficit as imports falter. I should like to emphasize that this view of dollar and bond market strength isn’t a long-term call, but intermediate, based on the prevailing negative consensus about bonds and the U.S. dollar and my expectation that the economy might suddenly fall off a cliff.”

In short, we believe the US dollar would probably rise in forex markets during a short squeeze event, but the rise would be temporary and have limited upside.

George J. Paulos’ Insightful Conclusion on the Synthetic Dollar Short

Both Sol and I acknowledge the possibility of a period of hyperinflation. Still, a whiff of hyperinflation could be the trigger for a cash short squeeze by diverting precious income from discretionary consumption to non-discretionary consumption and debt service. I believe we have already experienced that whiff of hyperinflation, and the damage has already been done to consumers who have increased their non-discretionary debt-service expenses while incomes have remained stagnant. As a result, consumers are increasing their debt loads even further to maintain lifestyles. This is not sustainable. The debt service burden will soon reach a tipping point.

The end game of unlimited monetary expansion is eventual currency collapse. Economic expansion and currency debasement are not just a US phenomenon. All central banks are playing this game. This is why currency collapse will probably include all major national currencies due to their unstable fiat nature and need to maintain relative parity.

If all major currencies collapse, their relative value may not change dramatically, but buying power would be severely reduced as inflation becomes globalized. As a result, the world will be forced into a new global currency valuation model. Such a new model may be gold-based but could also be a novel system based on a basket of commodities. The best way to play the currency debasement game is through gold and silver.

Global Currency Collapse Unlikely in the Near Term: Current Outlook

However, the collapse of other asset classes may be. This is where the danger lies in the cash-short squeeze scenario. A rush out of some large asset class could create a shortage of ready cash to settle transactions, causing massive declines in those assets and resulting in a deep recession. Cash is like any other asset class: “You got to know when to hold ‘em, know when to fold ‘em, know when to walk away, and know when to run.”

“… the least desirable asset today is cash. Therefore, a contrarian investor should consider
holding above average cash positions.” – Marc Faber, Sept. 2004

George J. Paulos is the Editor/Publisher of Freebuck.com, a website devoted to wealth preservation and enhancement using alternative investing approaches, including precious metals. He is also Associate Editor of The Gold Letter, a newsletter covering junior mining and natural resource stocks.

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Synthetic Dollar Short: Conclusion by Sol Palha

So to summarize, the dollar short will result in deflationary forces taking the lead for a while. Currently, they are both co-existing pretty much in harmony. The Feds will come out with an aggressive attack which could lead to hyperinflation; this could, in turn, lead to consumers cutting back on their expenditures simply because their salaries are not keeping up with inflation, and it’s going to take more of the same old dollars to buy the basics that they need to survive.

This, in turn, will trigger deflation in full force as we have mass bankruptcies across the board. The dollar’s rise will trigger a drop in the value of some of the now stronger currencies; however, no nation will allow its money to get too strong. So we will enter the competitive currency devaluation phase, where one either devalues or dies. In the end, the death of the dollar will bring about the future of fiat and possibly the implementation of some Gold standard.

Jan 31, 2019 Update on Synthetic dollar short

Pretty much what we originally stated in 2004 came to pass; Inflation rose, and Gold prices started to soar. The masses began to speculate, which produced the housing bubble, which led to the financial crisis and market crash of 2008. Interest was aggressively scaled back until it almost hit zero, and we entered a phase of massive speculation. However, this speculation was restricted to the big players as the small player was cut out of the credit markets. Hence despite this bull market soaring to new highs, the masses have still not fully embraced it, and until they do, sharp pullbacks should be embraced.

The 2008 Financial Crash and its Impact on the USD

It took a bit longer for the deflation beast to rear its head fully, but in 2011, we stated that the Dollar was ready to embark on a multi-year Bull and that Gold would put in a long-term top; both these events came to pass, and Gold is still having a hard time breaking its downward trend.

As the US has the highest rates in the developed world, the dollar will remain the most attractive currency as growth in Europe remains weak, and Asia is facing strong winds, so rate hikes are out of the question. When the US starts to lower rates, the other nations will be forced to do likewise, which still puts the dollar in the enviable position of number one.

Originally published on October 5, 2004, this remarkable piece of work has undergone multiple updates over the years, culminating in the most recent update completed in January 2023.