Tuesday, June 9, 2009

Thoughts on the dollar

This chart is a fairly common measure of the dollar's value against other major currencies. By this standard, the dollar has lost one-third of its value since early 2002. The Euro, the Pound, and the Yen have been the major beneficiaries of the dollar's weakness.

This next chart shows the value of the dollar against a very large basket of currencies (over 100), and it covers a much longer period. By this standard the dollar is very near its all-time low, and it has lost almost half of the value it had at its peak in March 1985.

This chart is arguably the best measure of the dollar's value against other currencies. It measures the dollar's value against a very large basket of currencies (also trade-weighted), but it adds a nice feature which is inflation-adjustment. That eliminates the problem that occurs when, for example, the dollar falls from 300 yen to 100 yen (as it did from 1973 to recently), but Japanese inflation is much lower than U.S. inflation. Without an inflation adjustment, you would say that the dollar lost two-thirds of its value, but that would overstate the true loss of the dollar's purchasing power. If Japan has less inflation than we do, then you would expect the yen to appreciate against the dollar in order to keep purchasing power across constant; by adjusting for inflation you would say that the dollar's loss of value was much less than two-thirds. (In round numbers, Japan has had 50% more inflation than we have had since 1973, so the dollar's purchasing power has only dropped by about one-third.) Since the U.S. has had more inflation, on average, than many of our major trading partners, this method shows that the dollar's loss has not been so dramatic as is reflected in the other charts. By this standard, the dollar is only about 6% below its average of the past 36 years, and it has lost about 20% of its value since its 2002 high.

This chart is arguably the best measure of the dollar's value overall, if you believe that gold has monetary characteristics and that it holds its value over long periods relative to other things. Since early 2002, the price of an ounce of gold has risen from $300 to $950, which is equivalent to saying that the dollar has lost about two-thirds of its value relative to gold (an ounce of gold buys just over three times as many dollars, so each dollar buys about one-third as much gold). But since the dollar has effectively lost only 20% of its value against other currencies over the same period, we know that other currencies have lost roughly 60% of their value against gold. In short, all currencies are quite weak today, judged from a gold-standard perspective.

So now we come to this last chart, which shows how the value of the dollar since last year has had a very tight, inverse relationship to equity prices (i.e., a weaker dollar has corresponded to higher equity prices, and vice versa). I've posted this chart before, and pondered its significance, without drawing any firm conclusions. In the context of the above charts, and the conclusions to which they lead me (i.e., from an historical and inflation-adjusted perspective the dollar is not particularly weak against the world's currencies, but all currencies are very weak relative to gold), I offer the observation that the dollar has been acting like a barometer of risk aversion over the past 18 months—rising as equity prices fall, and falling as equity prices rise—a sort of safe haven currency. That behavior is also observed in the growth of U.S. currency, whic surged from last September through March of this year: as financial conditions deteriorated, the demand for $100 bills literally exploded; currency grew at a 16% annual rate.

The dollar is now settling back down, and currency growth has been zero for the past two months. People are less fearful in general (the Vix Index is at its lowest point since mid-September, job losses have slowed down, banks are paying back their TARP money, commodity prices and global trade are picking up) and so more willing to believe that the future looks less and less likely to be a depression, and it might even offer the prospect of a return to growth, albeit tepid. They are trading in their dollars for equities. So it makes sense for the dollar to fall as equity prices rise. This is perhaps one of the very few times when I would say that a weaker dollar is a good sign.

Having said that, let me quickly add that I think the pronounced weakness of all currencies against gold is a very disturbing development which portends higher inflation and an eventual return to roller-coaster monetary policies worldwide. I've noted in recent posts that I think it is now past time for the Fed to begin withdrawing its liquidity injections and raising interest rates, and by the same logic other major central banks should be doing the same.

The good news is that fear continues to decline, and confidence is returning. The U.S. economy is beginning a new growth cycle, and the global economy also appears to have recovered from the airpocket that it hit last year. The bad news is that the future is not as bright as it could otherwise be; we are going to have to contend with the growth-dampening effects of excessive growth in government spending and regulation, higher taxes and erratic monetary policy for years to come. That's a bummer, to be sure, but I don't see that it is a reason to be pessimistic given the depressed valuations out there.


vincent said...

couldn't you argue that in a leveraged economy the excess supply of dollars are a function of collateral values and that when collateral (stock prices being a proxy) rises the supply of dollars expands thus the value falls and conversely when collateral falls dollars contract making them worth more?
ie the reason the dollar rallied while the fed doubled the size of its b/s is because the banking system's b/s was a black hole that evaporated the excess supply. now that stocks have rallied there is no more shareholder equity evaporation and the excess liquidity by the fed is allowed to work thru the system

vincent said...

btw really enjoying the updates - very value added analysis

Scott Grannis said...

If you want to boil down all the things happening which influence the amount of dollars and the value of the dollar, I would offer the following:

The value of the dollar is determined by the intersection of the Fed's willingness to supply dollars, and the world's demand to own dollars. The Fed has been very willing to supply dollars for the past 7-8 months, and the world has been very desperate to own dollars (and that includes those who want to pay down their dollar debt; having dollar debt is equivalent to being short dollars). The two forces have been in rough balance, leaving the value of the dollar unchanged relative to other currencies since last September.

Equity prices are reacting to the improved prospects for growth.

vincent said...

exactly to my point, if you are short 8 dollars of debt v 10 dollars of an asset and you sell the asset at 5 and the bank writes off 3 towards equity then there is a net loss of dollars from the system - the fed could not supply enough dollars to offset the de-leveraging at discounts

but that's not a desire to own dollars per se (flight to quality) its just a desire to buy back a short due to falling collateral (de-lever)- when the trade is over you don't have more people owning dollars, you have fewer shorts (supply) and thus less in circulation

conventional wisdom suggests that its the former when imo its more of the latter

Scott Grannis said...

I think we're on the same track. Deleveraging creates demand for dollars to pay back debt. Lots of forced deleveraging due to asset price declines. The Fed has done what it had to do to help satisfy the demand for dollars. But as the deleveraging fades away, the Fed will have to mop up those dollars just right, otherwise they will fuel inflation. An excess of dollars can depress demand for dollars--money becomes a hot potato that nobody wants when inflation starts kicking in.