Monday, August 3, 2009

Why a weaker dollar is good for stocks (2)

Here's an update on this very important and intriguing issue. Normally, I would say that a weaker dollar is a bad thing (since from a supply-side standpoint a stronger currency is always preferable to a weaker currency, since a strong currency inspires confidence and confidence generally leads to more investment), but as the second chart shows, for the past several months equities have been rising significantly even as the dollar declines. I've argued before that one way to explain this is to realize that the dollar's value has been driven primarily by the world's demand for dollars as a safe haven. That is illustrated in the first chart, which compares the dollar's value relative to other major currencies to the growth of US currency outstanding. In the past year this relationship has been more pronounced than at any other time I'm aware of: dollar strength has occurred during a period of major accumulation of US currency, most of which is held overseas.

On the margin, demand for dollars has dropped. With currency growth now almost back to zero, the dollar is declining, and equities are rising. This means that confidence is rising on the margin, and the next shoe to drop will be rising spending and perhaps a decumulation of dollars. Of course, rising spending a is not really what drives an economy to new high levels; for that you need investment spending. So far, I don't see signs of a big increase in investment spending, which is one reason I've been saying that this will be a sub-par recovery.

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