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I've been showing this chart off and on for the past year, with an extensive post on the subject last December, which by the way deserves re-reading. What's noteworthy now is the breakdown in the strong negative correlation (~0.95) between the dollar and equities that persisted from Sep. 2008 through Nov. '09. While most pundits viewed the negative correlation as symptomatic of the "carry trade," I thought it had a lot to do with the demand for money. The dollar was on the receiving end of the flight to safety that was precipitated by the financial crisis of '08, and the reversal of that move is what pushed the dollar down and equities up. Dollars that were hoarded in late '08 and early '09 were subsequently released back into circulation, and this helped spark a recovery both here and abroad. A weaker dollar and a stronger economy thus went hand in hand.
What we've seen since last December is a stronger dollar and a stronger equity market. (Note that the chart plots the dollar on an inverted scale.) As I said back in December, this suggests that the economy is improving on its own merits. What's good for the economy is also good for the dollar. People were very scared a year ago, but that fear has been slowly waning for many months; as fear subsides, the price of risky assets rises, and spending and economic activity improve as well. A stronger economy improves the valuation of the dollar, because a) it improves the expected returns on equities, and b) it means the Fed is less likely to be too easy for too long.
Parenthetically, a good friend asked me over the weekend why the passage of healthcare is being accompanied by higher equities, when it portends more government control of the economy and higher tax burdens. Shouldn't the market be depressed by the passage of a bill that calls for a gigantic expansion of the role of government in the economy? Here are some possible answers: a) the market doesn't believe the healthcare bill will survive the numerous challenges it faces; b) the huge opposition to the bill which was evidenced around the country and in every public opinion poll is a good sign that the era of Big Government has hit the high-water mark; c) the market is still trading at very depressed levels (as I have argued repeatedly); d) the market's rise over the past year has been driven primarily by the huge change between the market's initial expectations and today's reality (i.e., one year ago the market expected a gigantic depression, and instead we find ourselves in a recovery); and e) the healthcare bill won't translate into meaningful changes in policy or taxes for several years at least, so for now the dominant factor driving the equity market remains the underlying improvement in the economy.
If I could summarize all the possible reasons for why the dollar and the equity market have moved higher of late, it would be this: both the dollar and equity valuations remain depressed from an historical perspective, but the dominant changes on the margin have been positive for the economy (a recovery instead of a depression), while the passage and implementation of the healthcare bill is still very much up in the air.
UPDATE: To back up my inclination to view positively the current state of affairs, some quotes from George Will's recent column:
"And everybody praised the Duke, Who this great fight did win."
"But what good came of it at last?"
Quoth little Peterkin.
"Why that I cannot tell," said he, "But 'twas a famous victory"
-- Robert Southey, "The Battle of Blenheim"
Now, perhaps, comes Thermidor.
That was the name of the month in the French Revolutionary calendar in which Robespierre fell. To historians, Thermidor denotes any era of waning political ardor. Congressional Democrats will not soon be herded into other self-wounding votes -- e.g., for a cap-and-trade carbon-rationing scheme as baroque as the health legislation. During the Democrats' health-care monomania, the nation benefited from the benign neglect of the rest of their agenda. Now the nation may benefit from the exhaustion of their appetite for more political risk.
8 comments:
Scott,
Could it also be that the market likes "certainty" and with the passage of health care, businesses will at least have an idea what to expect? I remember talking to some developers who specialize in health care facilities several months ago and they said once something was passed, they would start building again. I know this may be counter to your suggestion that there will be fights over this and it may be struck down, but perhaps a lot of folks are ready to move on and work around this just like they have with other legislation in the past that seemed at first blush to doom our economy. I hate this bill as much as you do, but I also think this country is amazingly adept at finding a way to overcome whatever the Congress throws at us.
Bill: It's hard for me to argue with you on this, since I agree that the economy is very dynamic and it is very risky to underestimate the economy's ability to overcome adversity.
But I can't convince myself that this bill and all it entails is settled. Nothing will take effect for a long time. There are a lot of serious challenges and obstacles for the bill to overcome. The political environment is definitely in flux. There are important elections nearing that could make a world of difference.
If anything, there is still so much uncertainty surrounding the bill that I prefer to think that the current reality of a slowly improving economy is what carries the day.
A stronger economy improves the valuation of the dollar, because a) it improves the expected returns on equities, and b) it means the Fed is less likely to be too easy for too long.
Ya sure. On that basis the economy has been a wee bit of a tailspin since 2002, no.
Your short term correlation (cough, cough) chart is meaningless. A wee bit of a dollar bounce in a secular decline. The trade weighted dollar is lower than the 666 S&P500 print 54 weeks ago.
Scott,
I think the market rose today for one basic reason:
A free market is where business has a very tough time making money. Over time, in a free market, profits are driven to zero, i.e. just covering the cost of capital.....health care is now anything but a free market....and thus potentially more profitable!
Consumers will suffer because of Obamacare, not business.
Regards,
Michael
Mr. Grannis,
I think the market didn't react for several reasons:
1. The high probability of HC "reform" has been assumed since the Dem takeover of all government branches;
2. The likelihood that public outrage will crush the Dems in the next 2 or 3 elections, leading to gutting or outright repeal of the bill. Pat Caddell, a Dem pollster, has described the bill as Jonestown koolaid for the Dems; Rove and Morris project Dems will lose the House, etc.;
3. A large part of the investment community, strangely enough, is comprised of Dems, some of them very liberal, such as Buffet, who think HC "reform" will actually create economic benefits. Economic and political wisdom do not necessarily accompany investment acumen.
I believe your blog is the best macroeconomics blog out there. I read it every day.
-C. David Kirby
Michael: I think you are a bit too cynical on the subject of free markets. The role of free markets is not to drive profits to zero, it's to maximize the utilization of scarce resources. Businesses must earn a profit, otherwise no one would want to own or start one. Government control of the healthcare industry will almost certainly make that industry less efficient, thus hurting profits in that sector and reducing everyone's living standards from the level they might otherwise have attained.
The market has moved higher exactly because of the health care bill.
Over the past 2 years the government has taken over the entire US economy. The Fed absorbed the risk of the financial market and so did every other Central Bank.
Don't fool yourself. The health care bill removes even more uncertainty from what is left of the marketplace.
All of this makes the 'New Normal' look more likely as the days go by.
In a "new normal" environment, corporate profits are going to be hard to come by. How do you square this expectation with the ongoing increase in equity prices?
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