Friday, August 28, 2009

Dollar update: inflation forces are brewing

The dollar is struggling. It hasn't suffered a knockout punch, but it is definitely weak and appears to be in a declining trend. These charts are two different ways of looking at the value of the dollar. The first is arguably the best way to measure the dollar's value relative to the currencies of all our trading partners (it's trade-weighted and inflation-adjusted). It's telling us that the dollar today is only about 6% above its all-time lows. The second chart measures the dollar's strength against gold, and it is telling us that the dollar is within inches of all-time lows (gold being inches from its all-time dollar highs). Gold has in fact gained against all currencies in the past few years.

As a supply-sider, I believe that strong currencies are always better than weak currencies. As a next-best alternative, I'll take a stable currency. Currency stability means that over time purchasing power will be stable. Stable purchasing power does wonders for one's investment perspective, since it eliminates an important source of risk (i.e., inflation) to investment. Stable and strong currencies thus tend to be magnets for the world's capital because they offer lower hurdle rates to investment. Those countries that attract capital tend to have strong economies and relatively high living standards, thanks to strong investment.

As my previous post indicated, a weaker dollar has enhanced the returns to overseas investing. All of the world's equities markets are rising, but when measured in dollars, the U.S. market is a laggard and foreign markets are the frontrunners (e.g., the Brazilian stock market is up 140% from its November lows when measured in dollars). In my way of seeing things, a weak dollar acts like a headwind to recovery, since it reduces the amount of investment capital we might otherwise receive from the world. Obama's big-government spending and tax increases won't kill our economy, and neither will a weaker dollar, but they do amount to serious headwinds that will significantly increase the amount of time necessary for the U.S. economy to recover its previous potential.

The dollar enjoyed a brief period of strength in the latter half of 2008 (through mid-November), thanks mainly to a global flight to quality. Being the world's reserve currency meant that the dollar was the safest port in what proved to be a Perfect Storm. The demand for dollars exceeded the Fed's willingness to supply dollars late last year, and so the dollar's value rose against most other currencies and rose against gold as well.

Now things are reversing. Global demand for dollars is declining as the prospects for the global economy improve. Meanwhile, the Fed remains extremely accommodative, willing to supply an almost unlimited amount of dollars. Loan demand has not been very strong, however, so the vast majority of the reserves the Fed has pumped into the system remain idle. Instead of borrowing more, it seems that an awful lot of people and firms are still trying to deleverage. But as the recovery progresses and confidence returns, the demand for dollars is likely to fall relative to the Fed's willingness to supply dollars (and loan demand is likely to pick up), and that will erode the dollar's value, at least in terms of gold if not vis a vis other currencies. A weaker dollar will be a key indicator of an excess of dollars, and that is the essential ingredient for rising inflation. Ultimately, a weaker dollar increases inflationary pressures, regardless of how weak or below-trend the economy is.

Measured against gold, all of the world's currencies are in trouble, with the possible exception of the yen, which has only dropped 13% against gold in the past two years. Like many others, I believe that gold is a good way to measure the value of a currency in absolute terms, since gold has done a good job of maintaining its purchasing power over long periods, and countries who have pegged their currencies to gold have invariably experienced very little or no inflation. It would appear that all the world's major central banks are following the Fed's lead, aggressively supplying bank reserves in an effort to avoid a banking crisis. That's fine for the moment, but the price we're likely to pay will be higher inflation all over the world in the years to come, particularly if central banks are slow to withdraw their liquidity injections.

Given the trends so far this year, I think prudent investors need to be prepared for rising inflation in coming years and for sub-par U.S. growth (i.e., 3-4% growth, instead of the 6-8% that we would expect if this were a headwind-free recovery). TIPS are a conservative way to protect money from inflation, since they are adjusted directly for inflation and they pay a coupon (i.e., real interest rate) to boot. Gold and commodities are more aggressive, and much more risky, ways to protect against inflation, since a) they pay no interest rate, and b) they are well above their recent lows and their potential gains or losses are significant. Emerging market economies should continue to do better than industrialized countries, since they benefit from a weaker dollar and rising commodity prices, and many of them (e.g., Brazil, Chile, China, Peru, Singapore, Thailand) have managed to keep their currencies quite strong relative to the dollar in recent years. Equities in general should do well, since markets are still braced for recession and fear continues to distort investment decisions. The things to avoid like the plague are the "risk-free" investments such as T-bills, T-notes, and T-bonds.


Jeff said...

Scott, two questions. Why do you say avoid gold when you say "gold has done a good job of maintaining purchasing power over long periods"?

And two, why avoid short t-bills in a rising interest rate environment? I'm still scared of many things, including inflation and more government action (i.e. socialism). I'm avoiding anything long term. But why not ride short treasuries up?


Scott Grannis said...

I'm not saying to avoid gold, I am just noting that while you could certainly profit from gold if monetary policy continues to be too easy, you could also lose a lot. There is no guarantee that gold will rise forever, even if policy is inflationary.

The problem with short bills is that they pay almost zero interest, and so your investment is completely exposed to whatever inflation there may be. For safety, it's better to choose TIPS.

DaleW said...

TIPS are a conservative way to protect money from inflation, since they are adjusted directly for inflation

They are adjusted in a bogus way, unfortunately. All the hedonic adjustments and little fixes in CPI make me wary that TIPS will not preserve all one's purchasing power lost to inflation. They're better than nothing for a super-conservative investor, I guess.

Scott Grannis said...

I know an awful lot of people distrust the CPI, but I have spent almost 30 years working with different measures of inflation and have reluctantly (I too was a skeptic for a long time) come to the conclusion that it actually does a pretty good job. In fact, I think it somewhat overstates inflation. Several serious studies have been conducted, such as by the Boskin Commission, and they have come to the same conclusion. This ends up being a plus for TIPS, since you get overcompensated for inflation.

DaleW said...

Thanks; I will search out the Boskin report.

tom said...

Scott ... I started reading your blog just a few weeks back (I think it was a reference from John Rutledge.) Your posts are among the best on the web on the economy (to my mind even better than the WSJ blog). I commend you for your focus on data and the reasoned way in which you present your thoughts. I will no doubt continue to follow your blog on a regular basis!

I was reading an article by Andy Xie this morning. Andy becomes rather speculative towards the end of his paper and does not back up his theses by hard data. If you have a chance to read it, I would however be interested in your views on his article.


Thomas Bjurlof

Scott Grannis said...

Tom: thanks for the comments, much appreciated. As for the Xie article, it's not convincing. I've never paid much attention to savings rates because, at least in the U.S., they are very misleading. No one really knows what the savings rate is, in fact. For example, it's currently calculated in a way that counts realized capital gains as dissaving (because they generate tax liabilities), but doesn't count unrealized gains as savings. So it's hard for me to follow his argument since he spends so much time arguing that one savings rate has to increase while another has to decrease. In my view, markets are always adjusting unconsciously to whatever the forces happen to be dominant at the time. Governments can't control savings rates, and consumers never make a spending decision based on whether savings rates are too low or too high here or in China. Also, I get uncomfortable anytime someone talks about structural "imbalances."

I like to look at changes on the margin, especially changes that influence behavior.

Finally, I don't see that there are emerging bubbles. Yes, stock prices and commodity prices are up, but I would argue that stocks are still depressed in valuation terms, so that doesn't exactly qualify as a bubble. Commodity prices are still way below where they were a few years ago, and I don't think we can blame it all on Chinese speculation or manipulation; demand is up, that's pretty clear.

Higher gold and a weaker dollar suggest that monetary policy is accommodative, but I don't see the extremes here that would suggest a bubble.

Fiscal policy has been "stimulative" by one definition, but I think it has actually been depressing economic activity. Most of Obama's programs involve taking money from one person and giving it to another. That's hardly stimulative, and in fact is a headwind to growth since it creates perverse incentives.

tom said...

Thanks Scott.

I am not an economist, and I never understood the discussion of savings rates. Good to know that I do not have to pay attention to it!

There are a few writers on economics/investment that write in an engaging manner but leave one wondering what actually was said or why one should believe them. Andy Xie sounds convincing in most of his papers, but I am not able to tell whether he is right or wrong. I appreciate your feedback on the article.

Since I retired, sort of, a couple of years ago I have been reading up on economics/investing. Your blog is of great help and also leads to all sorts of follow up research on my part, which is great fun.

Your comment about Obama's redistribution approach is spot on. Mind boggling that these "bright" economists come up with nonsense such as cash for clunkers. "Let them eat cake!!!"