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Grab the Reins on the Dollar

June 1, 2015 1 comment

Let us all grab the reins on the dollar. Yes, it is true: the buck is up some 25% from a year ago, and at the highest level in more than a decade. After retracing recently, the dollar index has been chugging higher again although it has yet to penetrate recent highs. But put this all into context. In the early 1980s, the dollar index exceeded 160 before dropping nearly by half. A subsequent rally into the early 2000s was a 50% rally from the lows and took the index to 120. This latest rally is a clear third place, but also a distant third place (see chart, source Bloomberg).

buck

We can probably draw some instruction from reviewing these past circumstances. The rally of the early 1980s was launched by the aggressively hawkish monetary policy of Paul Volcker, who vowed to rein in inflation by restraining money growth. He succeeded, and took core inflation from nearly 14% in 1980 (with the dollar index at 85) down to 4.5% in 1985 (with the dollar index at 160). If you make a thing, in this case dollars, more scarce, its price rises. An optimistic press wrote about the “Superdollar” and the return of that signature American optimism.

Well, one out of two isn’t bad. The dollar soon slipped back, as other central banks instituted similar monetary restraint and the relative advantage to the greenback faded. It bounced around until the late 1990s, when Congress attacked the federal deficit – actually turning it into a surplus in the late 1990s. The dollar rallied fairly steadily from 1995 until topping out between late 2000 and early 2002, thanks to aggressive easing action from the Fed which took the Fed Funds target rate from 6.5% to 1.0%.

But it is important to remember that with currencies, it is all relative. If everyone is easing or everyone is tightening, then there shouldn’t be much in the way of relative currency movements. Thus, even though the Fed has spent most of the last seven years doing quantitative easing, the dollar hasn’t done much on net because everyone else is doing so as well. All currencies should be cheapening relative to real assets (and are, with respect to real estate, but not so much with commodities…for reasons that make little sense to me), but not relative to one another.

But recently, the dollar has outperformed because the investing community collectively perceived a divergence in monetary policies in the offing. While Japan and Europe have been ramping their QE higher, the Fed has ended its QE and at least some people expect them to raise rates soon. If it were to actually happen that money growth in Japan and Europe continued to accelerate while it slowed in the U.S., then it makes perfect sense that the dollar should appreciate. That is happening a little: the chart below (source: Bloomberg) shows that in the most recent data, European M2 money growth exceeded US M2 money growth (as well as UK and Japan M2 money growth) for the first time since 2008. Look at that spike on the red line in the chart below!

themsOn the other hand, there doesn’t seem to be anything dramatic happening on that chart, with all growth rates between 3.5% and 6.1%. And, honestly, I think investors have it generally wrong in thinking that if the Fed hikes US interest rates, money growth should slow and overall monetary conditions should tighten. Quite the contrary: I believe that with enormous excess reserves in place, rising interest rates will only spur bank interest in lending, and money growth will not slow but may even increase. But in any event, dollars are not about to become more scarce. The Fed doesn’t need to do any more QE; the vast quantities of excess reserves act as a reservoir of future money.

I have been surprised by the dollar’s rally, but unless something changes in a more serious way I don’t expect the rally to end up resembling the two prior periods of extended dollar strength.

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From May Day to Mayday

May 31, 2012 9 comments

By the time the calendar turned to May, one month ago, we already knew that the economy was weakening. The jury is still out on whether the weakening in the U.S. economy is due entirely to payback from the unseasonally good winter weather, but over the course of the month it became clear to most observers that the data were coming in soft. The exception to that rule was the inflation data, but we have been assured that worry is needless.

But back in the halcyon days of April we were just beginning to realize that the Greek “bailout” had not kicked the can down the road sufficiently far. Bankia had not failed, and Spain was not yet so threatening as it is today. And certainly, the head of the ECB had not yet taken to calling the Euro framework “unsustainable,” as he did today:

“That configuration that we had with us by and large for ten years which was considered sustainable, I should add, in a perhaps myopic way, has been shown to be unsustainable unless further steps are taken,”

Lest we forget how far we traveled in May, here is a quick summary of the way we were: (Source: Bloomberg)

4/30/2012

5/31/2012

Change
Crude

104.87

86.54

-17.5%

Gasoline

318.44

282.5

-$0.36

DJUBS Ag

160.8088

144.8983

-9.9%

DJUBS Softs

153.9553

135.8419

-11.8%

DJUBS Prec Metals

514.6371

477.9181

-7.1%

DJUBS Ind Metals

326.637

295.1249

-9.6%

Dollar Index

78.776

83.066

5.4%

S&P 500

1397.91

1310.33

-6.3%

Spanish 10y yields

5.77%

6.56%

+79bps

US 10y yields

1.92%

1.56%

-36bps

US 10y real yields

-0.35%

-0.56%

-21bps

US 10y breakevens

2.24%

2.09%

-15bps

Those are the financial market indicators, but we could go further. Initial Unemployment Claims for the last week of April were 368k; for the last week of May, the figure was 383k. That would seem to be the wrong direction. ADP was also weaker-than-expected at 133k. More concerning perhaps was the Chicago Purchasing Managers’ Report for May, which fell to 52.7 (the lowest figure since 2009) instead of rising to 56.8 as expected. The chart below suggests that the recent numbers have been weaker than the prior numbers were strong.

Stocks sank, although slowly, until the S&P reached and briefly sank below the 1300 level again. Then, for the second time this week, the market rallied on a poll showing the largest pro-austerity party in Greece leading the largest cancel-bailout party by 26% to 24.3%. Yes, that’s right: a 1% increase in the aggregate value of the equity market in the U.S. in response to a polling that was within the margin of error!

If you sold in May, I hope you went away because there weren’t many places to hide. Bonds were the clear winners, but with core inflation rising in virtually every country that is obviously a limited-time offer. Today, year-on-year core inflation in Europe exceeded expectations for the second month in a row. European HICP ex-tobacco, food, and energy rose 1.6%, matching last month’s figure and the high since 2009. (You wouldn’t know this from the widespread headlines of “Euro Zone Inflation Drops to 15-Month Low,” focusing on a headline figure that pundits hope can be interpreted as giving the ECB more room to ease. I fully expect that to happen, and for the Fed to also ease as the European disaster grows more frightening. It isn’t necessary for inflation to be falling, and it won’t matter that core inflation continues to rise. Central bankers simply won’t consider inflation to be a matter of signal importance compared to recession/depression fears.

What a month it has been. And as May draws to a close, we are plainly getting close to a mayday cry.

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