Friday, May 14, 2010
The dollar has been in the limelight of late, benefiting from the euro's Greek travails, but as the last chart shows, the dollar in general is still pretty weak compared to where it's been in the past. And since gold is rising against all currencies, it makes more sense to say that the euro is weaker on the margin than the dollar, than to say the dollar is strong. The dollar is rising on the margin relative to a lot of currencies because the news here is somewhat better than the market had feared (i.e., less bad than expected), while the news overseas is either not continuing to improve or is underperforming optimistic expectations, particularly in Europe with the looming restructuring of Greek debt and the ECB apparently willing to monetize some debt to provide relief to struggling debtors.
The euro is still somewhat strong relative to its purchasing power parity vis a vis the dollar, but clearly weakening. The market is pricing in the increased likelihood that the political pressures for a Greek bailout will compromise the ECB's ability to run a tight monetary policy. The bearish euro trade likely has some room to room, because it would have to fall a lot more before it became cheap.
The currencies that are fundamentally strong these days, on a purchasing power basis (according to my calculations of PPP as shown on the charts), are the emerging market and commodity currencies. The Australian and Canadian dollars are about as strong relative to the dollar (on a purchasing power basis) as they've ever been, and ditto for the Brazilian real. But they do seem to be pushing their limits. When a currency is stretched relative to its PPP, the news has to continue to be awfully good (or awfully bad, as the case may be), in order to sustain those valuation extremes. So that means AUD and CAD are very vulnerable to any signs of a) weaker growth, b) tighter monetary policy in the developed world, or c) weaker commodity prices. Being long these currencies at these levels requires courageous conviction.
The yen is also fundamentally strong, but primarily because the Bank of Japan continues to pursue a very tight monetary policy—note that the steep upward slope of the PPP line reflects over three decades during which inflation in Japan has been significantly lower than in the U.S. The yen has a lot of tight money momentum going for it, but most of that is being counteracted by a persistently weak economy. Plus, at these levels it is clearly overvalued relative to its PPP and thus vulnerable to any bad news or just news that isn't completely supportive.
I've been moderately bullish on the dollar since last December (check my forecasts near year-end), but I am losing my enthusiasm as the dollar climbs. The Fed continues to insist it will remain super-easy for the foreseeable future, and that is a clear negative. At the same time I think the world is overdoing its concerns about the demise of the euro. The euro currency area is a bit larger than the U.S. economy; you don't just walk away from the euro because one relatively small country is having problems. Imagine telling the 300 million people in the U.S. that you're going to change from the dollar to the Can-dol-peso; the logistics alone, not to mention the political fury that would be unleashed, are mind-boggling. Europe has made its currency bed and it is going to have to sleep in it. At some point the majority of Europe is just going to have to ignore the Greek protests. And the Greeks are just going to have to trim their bloated government, and that won't be an unbearable task. For heaven's sake, all this government spending is a huge problem, so getting rid of it should be a huge relief.
Posted by Scott Grannis at 1:28 PM