Friday, May 14, 2010

Currency update








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.

38 comments:

John H said...

Scott-
I enjoyed your work during your Western Asset days and heard Larry Kudlow discuss your blog last week. Really enjoy your thoughts.

Can you discuss your calculation of PPP?

ronrasch said...

I enjoy them also Scott. What are you looking for from Italy, Spain, and Portugal based on what they may be learning from Greece's need to control spending>

Steve said...

would a population overlay do the US justice?

Ed said...

Thanks Scott - great job. Just one point.Financial assets held by private households in Germany at the end of 2009 totalled EUR 4.7 trillion. Thats a lot - isnt´t it.
And if you habe a look at these charts from the ECB - I agree "inflation is not a problem" at the moment. http://kollateralschaden.wordpress.com/2010/05/11/trichet-der-lugenbaron-der-ezb/

Scott Grannis said...

John H: PPP calculations are part art, part science. There are two components: 1) pick the date in time when you think purchasing power parity actually held (i.e., when prices in both countries were roughly equal at the prevailing exchange rate), and 2) calculate how the exchange rate from that point would change over time if it moved in proportion to the difference between the inflation rates of the two countries (which also requires choosing the best inflation measure). Thus the PPP exchange rate at different dates should always be the exchange rate that equates prices.

Scott Grannis said...

ronrasch: I think all those countries, and the U.S., are learning a big lesson. Greece is the best thing that could have happened for the Tea Party folks. I can see a new slogan: "Let's not follow Greece into the Big Government fire."

John said...

I believe many european legislators and government officials had what many southerners (as well as others) call a genuine 'come to Jesus' moment. I use this expression purely as an analogy for a shock that has the potential to change habitual behavior in an individual. The vision of a rioting public in an European capitol I believe has focused some minds on the stark fear that if it can happen in Athens it can happen in Rome, Lisbon, Madrid, even Paris if the contagion runs unchecked. Every european politician understands the implications of riots. The ECB has bought them some time. It is not knowable to what degree fiscal changes will occur but I believe behavioral changes have already occured and will continue to do so. It remains to be seen if it will be enough to convince the bond markets. So far, Spain and Portugal have sold bonds in public auctions successfully and have announced budget cuts. For the time being the sovereign bond panic is over.

Bill said...

I would be interested in thoughts on the chances that the Europeans will throw out the current leaders and replace them with those who will capitulate to the riots and continue spending unrestrained. Given how hard it is to wean the public off the dole, I am concerned that these countries will not be able to maintain the austerity pledges. Didn't the Spanish throw out their conservative government a few years ago and replace it with the socialists?

Scott Grannis said...

I would like to believe that the Greek crisis has been a wakeup call for just about every country facing big deficits.

John said...

Bill,

You raise a very good question. It remains to be seen how the various publics will speak on the issue of the European Union and the requirements and sacrifices required to remain one.

I do not know if it can be reduced to a local political issue but the big reason for forming the EU was to contain a dominant geopoliticly powerful Germany. Two devastating world wars have been fought in the last one hundred years that have required european economies to completely reboot. If the EU dissolves and returns to its old ways, the fear is that it will at some point result in another devastating war. It was this fear that for more than a generation a dream of an economicly unified Europe has been nurtured. There is a significant politcal constituancy in Europe that will fight to the end to save the EU for this reason.

For many people in Europe however, there is no memory or knowledge of european war. It will be a tough sell to convince these younger generations to sacrifice for the profligacy of others. The recent regional election in Germany was not encouraging. The issue of the EU will probably be one of the dominant issues on the continent in the next couple of years.

On the optimistic side, leaving the EU for, say, Spain or Italy would bring its own problems. These countries enjoy beneficial trade relations with other EU members and the common currency reduces transaction costs immensely for intra EU commerce. Going back to old currencies will be expensive and cumbersome, and will not altogether mean an end to government spending disciplines. There are powerful arguments for these larger countries to remain within the EU.

Each country will be facing these issues as time goes on, but I really have to give the edge to the establishment as of now. Greece may well crumble under the weight of their past transgressions but as I have said I really don't think Greece alone can bring down Europe. As long as Spain, Italy, France, get their fiscal acts together the problems will be managed...at least for the time being.

Benjamin said...

In the United States, a huge part of the dole is handed out to rural states, each of which have two Senators, regardless of population. This, the 17 most sparsely populated states have 34 votes, enough to block the Senate from cutting federal lard..
Ever wonder how we ended up with a $90 billion Education department, and to where the money goes?
Most rural states get back between $1.25 and $2.00 for every dollar they send to DC. They survive on subsidies and federal outlays.
On top of that, we have a military that Cato Institute says is roughly twice as expensive as it should be. But military outlays are sacrosanct- the far-righters like to hype the terrorist threat, and related spending.
Oddly enough, the Euro states may have an easier time cutting lard than we do. They do not maintain expensive militaries that are scared cows. I am sure they social welfare programs that are useless as they are in the US. They can cut those.
In the US, every department spends heavily in the rural states--and they will not tolerate cuts. Rural America would just about blow away without constant federal infusions of lard and subsidies.
So, they logroll.
I have not yet heard a peep from the Tea Party as to how they plan to cut outlays. Sure tax cuts. I want tax cuts too.
But spending cuts--see 2000-2006. You really think the R-Party can cut outlays? They are built on outlays. Lobbyists do not come to Washington DC and give money to get smaller outlays.
And, we are still hip-deep in two open-ended wars, each one a trillion-dollar undertaking, and one that we are not sure of winning after nine years.

There are unintended consequences of invading and occupying whole nations.

Greece may have it easy, compared to the UA.

John said...

Benj,

Both parties have been guilty. They both have their spending priorities and they both borrow and spend when in power.

It will soon have to change. It will be 'what do we cut' time. Whose ox gets slaughtered so the others can eat? Not gonna be pretty. I think everyone is going to have to sacrifice in as equal a measure as we can make it. Its still 'out there' somewhere in time but we will have to face it. I sure do hope we don't have to have a crisis before the politicians can get the political testecular fortitude to do what's necessary.

I'm not optimistic.

Bill said...

Well, on the optimistic side, I understand that the Katrina ravaged Hyatt Regency New Orleans got its financing for a $200 million renovation. That will employ thousands of construction workers. I'm also hearing from developer clients that deal flow is starting to pick up in commercial real estate. I hope this mess in Europe won't stall this good news.

Benjamin said...

John-
I agree 100 percent.

I am 100 percent an optimist when I meet American venture capitalists, investment bankers, people in manufacturing (especially).

But when I ponder the true shape of the federal budget, I get depressed.

True he-men live in Montana, no? In 2005 (latest year available) per capita in Montana paid $5,605 in federal taxes, and was larded down with $8,378 in federal outlays. (Source: The right-wing Tax Foundation).

I notice the Tax Foundation stopped doing this table, probably it pissed off their financial backers.

Amazing! Thus, everyone in Montana would have to pay nearly $3k more in taxes, or take a $3k cut in outlays, so that state would not be a subsidized state.

Since 2005, I am sure the situation is far worse.

How on earth are you going to collect another $4,000-$5,000 from every rural resident in the nation? Or cut spending in rural areas by that amount?

When the Tea Party starts talking turkey on this, then I will have hope.

Sometimes I proffer this solution: How about every state gets back roughly what they pay in to the federal till? That's a balanced budget, and even sounds like state's rights. The right-wing crowd suddenly is not interested in the topic.

This is the only aspect of the US that makes me gloomy about the country. Even the party that is supposed to be fiscally conservative is not.

John said...

Bill,

It probably will not. The crisis is over for the time being. Europe is a long way from New Orleans.

Incidently I have stayed in the Hyatt several times over the years on my many trips to the city of my birth. It remains one of my favorite cities to visit. The French Quarter is as unique as you will find in America. Galatoir's on Bourbon Street is as good as any restaurant I have ever been to.

John said...

Bill,

You've got me thinking about New Orleans tonight and I thought I would end the evening with a story for you.

When Ronald Reagan was in his first term as President he was involved in an issue that concerned Senator Lloyd Bentsen of Texas. This is the same Lloyd Bentsen that was later President Bill Clinton's Treasury Secretary. Senator Bentsen's staff in Washington informed the White House that the Senator was in New Orleans on vacation and that they would attempt to locate him. (remember this was the early 1980s and cellphones were not around) The concierge at the Senator's hotel informed the Senator's office that he was dining that evening at Galatoir's on Bourbon Street. Of course, the White House was promptly informed and a priority call was made instantly to the restaurant.

Now you have to understand that Galatoir's does not accept reservations and on weekends and most weekdays there is usually a line that snakes down the street for several hundred feet. It so happened that Senator Bentsen was in that line quite a distance from the door to the restaurant when the call from the White House arrived. The Maitre D' calmly went outside and announced in a loud voice that there was a call for Senator Bentsen from the White House and could he please come inside to take it. WELL. The crowd parted like the RED SEA in Exodous as the Senator walked in to speak with President Reagan.

A few minutes later the Senator walked back out the door and returned to his place in line several dozen feet from the entrance.

True story. I was a few yards behind the Senator at the time. From then on that guy was OK in my book.

Nite, ya'll

Paul said...

"I have not yet heard a peep from the Tea Party as to how they plan to cut outlays. Sure tax cuts. I want tax cuts too."

~Benji, pretending he knows any Tea Partiers.

"The right-wing crowd suddenly is not interested in the topic."

Oh yes, we hypocritical right-wingers just can't live up to Benji-The-Pure's expectations! Good thing your boyfriend, Pelosi, and Reid run everything and are showing us how it's done!

Public Library said...

You guys are drinking Koolaid. Cato just spoke about the R-Parties proposal to cut spending. A whooping .017%.

http://www.cato-at-liberty.org/2010/05/14/youcut-spending-by-0-017/

Public Library said...

Scott,

We are already in the Big Gov fire. The Fed is sinking this country one swap line and crummy credit at a time.

Benjamin said...

I have a loyal national reading audience of exactly one: Paul.

Thanks Paul, for noticing. BTW, I held my nose and voted for Obama. I was not sure a McCain-Plain ticket would not embroil us in even more wars.

Wars today seem to be trillion-dollar undertakings, even for middling affairs. Some say if you count VA expenses and debt, we are already in for $2 trillion just on Iraq.

Add that to the embedded deficit-spending the R-Party must provide to rural states, and you will never see a balanced budget from the R-Party.

BTW, in 2005 (well before Katrina), the residents of Louisiana received $8798 per capita in federal outlays, but paid only $4565.

Thus, every resident of LA would have to pay another $4k in federal taxes, or we would have to reduce outlays by $4k per capita in LA, or a combo of the two, just to bring LA to parity.

It is the same for every rural state. If we balance the federal budget, it will mean radical reductions of rural populations in the United States.

That is where the money flows to.

Still, it may be time. We can no longer subsidize rural roads, water systems, power systems, postal service, telephone service, crops etc etc etc.

We have created a knock-kneed, enfeebled, weakling economy in the outback. Time to wrenching and tough belt-tightening, but I call for it anyway,

Benjamin said...

BTW, Palladium has tripled since 2005, and is this year's hottest commodity.

I wondered why.

Then I read this in Wiki.

"Prior to 2004, the principal use of palladium in jewelry was as an alloy in the manufacture of white gold jewelry, but, beginning early in 2004 when gold and platinum prices began to rise steeply, Chinese jewelers began fabricating significant volumes of palladium jewelry. Johnson Matthey estimated that in 2004, with the introduction of palladium jewelry in China, demand for palladium for jewelry fabrication was 920,000 ounces, or approximately 14% of the total palladium demand for 2004—an increase of almost 700,000 ounces from the previous year. This growth continued during 2005, with estimated worldwide jewelry demand for palladium of about 1.4 million ounces, or almost 21% of net palladium supply, again with most of the demand centered in China. The popularity of palladium jewelry is expected to grow in 2008 as the world's biggest producers embark on a joint marketing effort to promote palladium jewelry worldwide"

In short--demand from Chinese jewelers (and consumers) is pushing up palladium prices.

This is yet another reason not to draw connections between Fed actions and rare metals prices.

It may be that Aunt Lee has her 70th birthday coming up, and nephews and nieces now have disposable income. Multiply that story by about one billion. And so palladium prices go up.

John said...

Public,

No question that we have one monumental job ahead of us. It will be interesting to see which political groups are willing to SERIOUSLY take on the problem of reducing the federal deficit.

John said...

News organizations are reporting success in stopping a significant portion of the Gulf oil leak.

Terrific news for a slow Sunday. Lets all hope the luck holds!

Bill said...

For all you folks who know a lot more about the markets than I do, what are you thoughts about the impact of the financial regulation pending before Congress? Could it be that the prospect of all this regulation is spooking the markets more than Euro zone troubles? Scott- perhaps we won't see your predicted growth in the S&P 500 this year because of the dumb regulations Congress is about to pass?

John said...

I have financials about even weighted in my personal accounts. That is quite high compared to most recommendations I have seen. I believe most funds are pretty underweight the sector.

As I look at the financials I see an industry with a lot of uncertainties. The legislation in Congress is only one. What the sector needs most IMO right now is clarity on what the rules are going to be. The markets hate uncertainty and we have had gobs of it this year with health care and now financial reform. I think given a decent economy going forward the banks will do fine as long as the more draconian parts of the draft are excluded from the final bill. It will probably be a few more weeks before we know for sure what it will be.

The bank stocks themselves have already seemed to discount a fair amount of bad news. The Euro crisis and its potential to damage bank balance sheets further did not help. However, the sector looks oversold to me and could soon begin to discount the coming resolution of the issues. As soon as the rules are known, the institutional investors can plug the variables into their models and get higher probability outcomes. Then they will committ capital. Without clarity, they will wait.

This is a short term problem IMO. I think it will soon be resolved. Given a continuing economic recovery, continued low rates from the fed, the eurozone issues fixed, however temporarily, and the strong underweighting of mutual funds in the sector, we could be setting the stage for a decent move in the quality names into yearend. Longer term, assuming no more macro land mines blow up in investors faces and a good economy, there is very good performance potential, as many of the financials have earning power significantly above current earnings projections.

Just FWIW I have some small positions in JPM, C, BAC, XLF, WFC, and AXP. Better returns have been made in the regionals recently but I have chosen to stay with the larger names. If you want to play the group, XLF reduces single stock risk and would be more conservative while BAC and C would be more aggressive with more return potential.

Bank stock investing is for risk capital. There is a lot of leverage, but as we have seen in the past couple of years, the leverage is a two edged sword. My advice to you is invest in quality and be prepared for volatility. But i do believe the worst is over for the financials...for the time being.

Paul said...

"Thanks Paul, for noticing. BTW, I held my nose and voted for Obama."

You held your nose, yeah, right. He captured your heart, and you jumped on the bandwagon like millions of other mindless voters.

And here we are running trillion dollar deficits for as far as the eye can see.

"Add that to the embedded deficit-spending the R-Party must provide to rural states, and you will never see a balanced budget from the R-Party."

Unlike your boyfriend, who is doing
a standout job!

I guess I have to keep reminding you the GOP did balance the budget in the late '90's, (though admittedly aided from an unsustainable bubble )with Bill Clinton kicking and screaming every step of the way - right up until he decided to take credit for it all.

GOP Gov. Chris Christie is leading the way in NJ, using a meat-axe against the Democrat voting public sector unions. Given the chance, you would have voted for Corzine.

I ask again, Benji. Where are the Democrat Chris Christies, Paul Ryans, and John McCains?

They don't exist.

Jan Rogozinski said...

Folk that worry about deficits and "debt" as of today -- those folk just do not understand economics.

We are in a period of extremely rapid deflation. That means that every day money buys more things, as the value of the dollar soars. At this point, the government must go into debt and try to knock down the value of the dollar; the alternative is 100% unemployment. The biggest problem today is that the government deficit is way too small. Unfortunately, Obama is a financial ultra-conservative, who wants to pay for every program he adds.

That's not saying that debt always is a good thing. In generally good times (for example, 2000-2007), the government ought to run a small surplus. But, of course, no Republican ever cares about the deficit; when in power, their goal is to increase subsidies to their corporate masters.

Scott Grannis said...

Jan: I suggest you go back and do your homework. Obama is trying as hard as possible to spend money we don't have. Check out my many posts on fiscal policy. The looming deficits are far more scary than the threat of deflation. Plus, you can't possibly argue that we are in a deflation when commodity prices are soaring and gold is trading at $1200/oz.

Erica said...

Hi Scott -

How did you calculate the $1.15 value for the Euro?

Thanks!

Scott Grannis said...

Erica: Be sure to read my explanation of how I calculate PPP above (5th comment in this thread). I freely admit this is not a purely scientific approach, and reasonable people could disagree with my conclusions. But I have used this approach for the past 30 years and it has served me well.

Erica said...

Thanks for the response Scott. Do you think you could provide an example? I am afraid I don't really follow that explanation. Thanks so much for you great work!

Scott Grannis said...

Erica: Let's assume, for the sake of argument, that today prices in the US and Europe are roughly equal with the euro at 1.22 per dollar. Now assume that one year passes, and inflation in the US is 10%, while it is zero in Europe. In order for prices to still be equal across borders, the price of the euro would have to rise by 10% (the difference between the two inflation rates), to 1.34. Even though actual prices in Europe would be unchanged, Americans would have to pay 10% more per euro, thus European prices would effectively rise by the same as US prices. 1.34 would be the new PPP value of the euro/dollar exchange rates

Erica said...

Thanks Scott. But how do you come up with $1.15 on the Euro?

Scott Grannis said...

Erica: Let's assume, for the sake of argument, that today prices in the US and Europe are roughly equal with the euro at 1.22 per dollar. Now assume that one year passes, and inflation in the US is 10%, while it is zero in Europe. In order for prices to still be equal across borders, the price of the euro would have to rise by 10% (the difference between the two inflation rates), to 1.34. Even though actual prices in Europe would be unchanged, Americans would have to pay 10% more per euro, thus European prices would effectively rise by the same as US prices. 1.34 would be the new PPP value of the euro/dollar exchange rates

Erica said...

Am I an idiot or did you mean to post the same comment?

Scott Grannis said...

Hmm, for some reason my post self-repeated. I have no idea how that happened.

To answer your question: my choice of PPP is subjective. That is the ultimate weakness of any PPP analysis, since the analyst must choose a moment in time when prices and economic conditions appear to be in equilibrium. If he chooses right, then the PPP that is derived by applying inflation differentials will in general be the exchange rate that will equilibrate prices at any point in time. It would be akin to the mean-reverting value of one currency relative to another.

If you need more details, I suggest you consult a textbook that covers international finance theory.

狂猪 said...

Hi Scott,

It took me a while to chew on what you've wrote here. I have a couple questions about the analysis. First, let me profess my ignorance in economics. I may be really off base here.

What role do inflation and inflation expectation played in the exchange rate and in the calculation of ppp? My understanding is current inflation rate is a backward looking measurement while inflation expectation is forward looking. If ppp depends on inflation (backward looking) while exchange rate depends on inflation expectation (forward looking), than perhaps ppp and exchange rate is not directly comparable?

In the last 10 years, both US and Europe enjoyed very low inflation. However, ECB has always been much more hawkish toward inflation than the Fed. As such, the inflation expectation in the US is higher than Europe. I think this higher inflation expectation accounted for the stronger euro prior to late 2008. In other words, the Euro was fairly priced and not over valued.

Today, because of Europe's $1 trillion rescue package and ECB's purchase of government bonds, the market is reconsidering the inflation expectation of Europe. As such, the Euro weakens. I think the same thing happened to the US in early 2009 when the Fed and the Treasury undertook numerous measures to strengthen the US financial system and the economy. At that time the Fed and Treasury was much more aggressive than their European counterpart. As such the market's inflation expectation of the US is higher and therefore the dollar continued to weakened until early 2010 when the Greek crisis surfaced.

I suspect the euro exchange rate will fall to match ppp only if the euro's inflation expectation matches the US. But that will not happen if the the ECB stays more hawkish on inflation than the Fed. Therefore, the fundamental question is did the current sovereign debt crisis changed the historically more hawkish inflation stance of the ECB relative to the Fed? I strongly doubt this because of the EU's governing structure and the ECB's mandate. Scott, what do you think? At any rate, I think when the current panic subsides the Euro will strengthen. Furthermore, today Europe is healthier than the US in terms of overall public debt and fiscal deficit.

Scott Grannis said...

狂猪: I think you have a very good understanding of the important issues. If the ECB can avoid caving in to political pressures, then the I agree the euro should rise once this crisis passes.