Another update in an important series of posts. The dollar has hit a new low for the current calendar year, and equities are making a new high. Coincidence? Craziness? No. The only plausible explanation for this is that the two phenomena are directly related. They both reflect an increase in confidence and a decline in the demand for safe assets.
The economic crash that happened last year was primarily driven by a widespread fear that the banking system was collapsing. No one was willing to trust anyone. People were desperate to increase their holdings of safe assets, and high on that list was dollar currency. The demand for money soared. Since then, the Fed has been going to remarkable lengths to increase the supply of money. If they hadn't, then we would have faced the real risk of deflation.
The story this chart tells is that we are now well into the process of recovery from last year's crash. People no longer want to stockpile dollar currency; the demand for dollars is returning to where it was before the crash. As the stockpiled dollars get spent, they are boosting the economy, helping it to recover to where it was before the crash. The stock market is the beneficiary not only of an increase in the velocity of money, but also an increased willingness to move from the safety of cash to risky investments once again.
As I've said before, a restoration of confidence is an essential ingredient to a recovery from this unique recession. Plus, it kickstarts a positive reinforcement cycle, since confidence sparks spending, and spending brings forth new confidence. We still have a ways to go to get back to where we were before everything collapsed last summer.
Scott,
ReplyDeleteI just read a book by Barrie Wigmore that is a year by year review of the period 1929 to 1933, the Crash and its Aftermath. Great book. I'm not a doomist, but the book says that in early 1933, FDR implemented a devaluation of the dollar. As this devaluation became apparent, the stock market surged, really surged. This surge then helped restore some confidence and attracted money to the equity markets, helping capital formation.
Any chance that the stock market increases are being driven by dollar devaluation. I note that David Goldman at Asia Times has noted the high correlation in his Inner Workings blog.
As the dollar devalues, the u.s. stock market becomes cheaper to foreign buyers in their local currency, therefore they can bid up stocks and still come out ahead. No different than foreigners buying condos in florida right now and pushing up prices (happening in beach areas of Florida, despite the massive price reductions). Dollar devaluation helps support prices, whether it is real estate or stocks, so long as they believe the devaluation is not going to be much worse.
Any thoughts on this angle. I'm intrigued by the 1933 dollar devaluation/stock market surge.
I suppose you could call this dollar devaluation, but that is looking at the process from the wrong angle. A weaker currency can be the result of too much supply, too little demand, or both. In this case, though it is obvious that the Fed is pumping up the supply, I think it is the declining demand for dollars that is the dominant factor on the margin. That declining demand is the flip side of an increased velocity of money. Money that was "sitting under mattresses" is now getting spent. That is a good thing.
ReplyDeleteOf course, this dynamic could change in the future, so these things bear watching carefully.
The parallels to the 1930s are limited, since we have obviously avoided the monstrous deflation which was one of the principal problems back then.
If you look at the flow data, you'll see that Americans have largely been selling the dollar to buy foreign stocks (esp. EM). I think this capital outflow has a lot to do with dollar weakness (and of course is what the Japanese did once yields got to very low levels, domestically). Whether you think that's confidence in economic recovery or concern about the prospects for the USD is up to you!
ReplyDeleteI'm very wary of using "flow data" to isolate one group of investors and thus claim that they are the ones pushing things around on the margin. There are so many variables (and people with lots of money) out there that I don't think it makes sense to say that the Americans or the Chinese are the ones pushing the dollar down on the margin.
ReplyDeletehi Scott --
ReplyDeleteI was wondering if you could comment on some things I've heard lately from economists David Rosenberg and Marc Faber related to the USD topic. I've condensed their main points as follows (my interpretation of course):
1) Real interest rates = 0 means that holding cash is BAD. Since the return on cash is zero, any excess cash is then put to work in riskier asset classes, ie, equities, homes, bonds, etc.
2)Deflationary pressures are ahead of us, not behind us. This is why 10 year treasuries are at 3.4% instead of their long-term average of > 5%. Deflationary pressures are provided by declining real wages, credit, and rent.
3) With deflation occurring, the FED will keep rates @ zero until signs of inflation show up (they have to, because premature tightening will kill the nascent recovery occurring right now).
4)CONCLUSIONS:
-- An equity asset bubble is forming bc of zero interest rates against a deflationary backdrop and a weak dollar.
-- The FED can't slow the growth of equity asset bubble without killing the economy; thus the bubble may inflate dangerously beyond the fundamentals. -- Since the FED doesn't portend to actively target equity & bond markets, it must keep rates low until signs of inflation creep up.
Scott -- please let us know if you agree (or disagree) with this line of reasoning regarding possible US equity asset bubble.
As always, many thanks for your thoughts,
Best,
Blake
Blake: Excellent question, really gets to the heart of the controversies out there.
ReplyDeleteI would disagree with Rosenberg and Faber on their assumption that deflation is a serious threat. Deflation is a monetary phenomenon, not the result of recessionary pressures on wages or rents. In recession there is lots of pressure for some prices to fall, but they fall relative to others. I don't seen signs of an economy-wide fall in prices. If we really had deflation going then I would expect to see the dollar very strong, gold falling, and commodities falling, much as we saw in the early 2000s. Instead we see the opposite. Monetary policy is easy, and they are right when they say that people are trading out of cash and into almost any other asset. That's how inflation happens. That's not how deflation happens though.
I also don't agree with their assumption that a Fed tightening would kill the economy. How can raising rates from zero to 2 or 3 be bad? For one, households have more floating rate assets than floating rate debt, so they would benefit from rising rates. Rising rates would also improve confidence in the dollar and reduce fears of inflation, and that would increase the incentives to invest here.
The thing that is most difficult for me to explain is why T-bond yields are so low. I think it is mainly because a) the majority of observers agree with Rosenberg and Faber that deflation is a serious threat because the economy is so weak, and b) the Fed has convinced the bond market that short rates will be very low for a long time.
I would note that the front end of the yield curve is about as steep as it has ever been; I think that supports my notion that what is holding down long rates is the perception of an extended period of short rates. It's very expensive to short 10-year Treasuries in this environment because you are up against the Fed and they are the most powerful player in town.
Finally, I don't see any sign yet of an equity bubble. Prices are very low historically. I don't see that valuations are stretched at all.