Dollar review: still very weak

By almost any measure, the U.S. dollar is at or near its weakest levels ever, whether nominally or in real terms. This is in part a reflection of the fact that U.S. inflation has tended to be higher than that of other countries, but perhaps more importantly, it shows that the market's outlook for and confidence in the U.S. economy is dismal.

This first chart is the most common measure of the dollar's value (DXY) as compared to a relatively small, trade-weighted basket of six major currencies (EUR, JPY, GBP, CAD, SEK, CHF). The dollar is bouncing along the bottom, today about 10% above its all-time low, and it has lost 50% of what it was worth at its peak in 1985.

This next chart is arguably the best measure of the dollar's value against other currencies. Calculated by the Fed, it shows the dollar's value on a trade-weighted and inflation-adjusted basis against a very broad basket of currencies (over 100), and against a smaller basket of major currencies. Again we see that today the dollar is only marginally above it's all-time lows and has lost one-third of its all-time high value in 1985, when the economy was booming and the Fed had conquered double-digit inflation. Since early 2002 it has lost 25% of its purchasing power against other currencies.

The chart above shows the dollar vs. the yen (blue line), and my calculation of the dollar's Purchasing Power Parity exchange rate against the yen. The idea of PPP is to start with a base value of an exchange rate, preferably chosen from a time when trade and capital flows were in rough balance and inflation differentials were minimal, and then adjust that value for inflation differentials. If country A has less inflation than country B, then country A's PPP exchange rate will rise against B's currency, as it must in order to keep prices equal in the two economies. (In all the charts here, an upward sloping line means that U.S. inflation has on balance between greater than the inflation rate of each individual country.) If a currency trades above its PPP, then it can be considered "overvalued" relative to the dollar, since prices in that country will be higher than in the other country, and a currency trading below its PPP is consequently undervalued relative to the dollar.

If a PPP calculation is done correctly (caution: it's more art than science), then if a currency tracks its PPP over time, tourists from each country traveling in the other should find that prices are roughly the same as what they pay at home for similar goods and services. In the case of Europe, my calculation of PPP suggests that prices in Europe today are roughly 13% higher than prices in the U.S. In other words, the Euro is about 13% overvalued against the dollar.

As this next chart shows, Japan has experienced significantly less inflation than the U.S. since the late 1970s, and that is reflected in the sharply upward-sloping PPP line for the yen. Not surprisingly, the yen has appreciated tremendously against the dollar since 1970 (100 yen buys 4.6 times more dollars today than it did then), as purchasing power parity theory would predict. By my calculations, the yen currently is about 50% overvalued against the dollar, meaning that for a U.S. tourist, traveling in Japan is very expensive.

In contrast to the ever-appreciating yen, the long-term trend of the the pound vis a vis the dollar has been down, as this next chart shows, because U.K. inflation has been higher than U.S. inflation. I was unfortunate to have my youngest daughter studying in London some 5 years ago, when the pound was at its strongest level ever relative to dollar. Today, prices in the U.K. are still more expensive than in the U.S., but not by much—only about 17% by my calculations.

The Canadian dollar today is almost as strong relative to the U.S. dollar as it has ever been, and on a par with the strength of the yen. What a contrast from its weakest level, back in 2002! With Canadian inflation being very similar to U.S. inflation over the past two decades, I doubt that the loonie is going to appreciate further. Canada likely has benefited as much as it ever will from the global commodity price boom. With the loonie trading at close to parity to the dollar, Canadians are finding U.S. prices irresistibly cheap, and on the margin this could put upward pressure on U.S. prices and downward pressure on Canadian prices. For that matter, tourists from almost all parts of the world are finding that U.S. vacations are cheap thanks to the weak dollar.

The story in Australia is very similar to the one in Canada. Like Canada, Australia's economy is heavily influenced by its bounty of natural resources, and commodity prices today are still very near their all-time highs. The commodity boom has been great for the Australian economy, and by extension great for the Aussie dollar. But given the current degree of overvaluation (over 50%), I doubt the Aussie dollar has much upside left. 

I haven't calculated the PPP value of the Chinese yuan, but this chart shows the real value of the yuan relative to a basket of currencies on an inflation-adjusted basis, as calculated by the BIS. What it shows is that since pegging its currency to the dollar at the beginning of 1994, the yuan has appreciated 68% in real terms against the currencies of its trading partners. That puts the yuan right up there with the yen in the ranks of strong and appreciating currencies in recent decades. Over this same 18 year period, the dollar (DXY) index has fallen 16%, and the Real Broad Dollar Index has dropped 6%, so the yuan has unmistakably appreciated in every sense, and significantly, against not only the dollar but against most other currencies. Protectionists in the U.S. should stop complaining about the supposed "unfair advantage" that a supposedly cheap yuan confers on Chinese exports. And anyway, if the Chinese want to sell us cheap stuff, why should we complain? Cheap Chinese goods only hurt a small segment of our economy (i.e., those few that have to compete with Chinese imports, which comprise less than 3% of what U.S. consumers spend every year), but they greatly benefit everyone else. And of course, the strong yuan is the flip side of a weak dollar. Why would we want to cheapen the dollar, since that can only make imported goods more expensive for everyone?

The dollar is worth only marginally less relative to gold than ever before. If the price of gold says anything about a currency's value, the 10-yr surge in gold prices is a gigantic vote of no confidence in the dollar, and an implicit bet by the market that the dollar will lose even more of its value against other things and other currencies in the future.

Non-energy, raw industrial commodity prices are only 16% off their all-time highs, but way above their average in the 1980s and 1990s. This also reflects poorly on the dollar's purchasing power, and it is no coincidence that the rise in gold and commodity prices started at almost the same time as the dollar's decline (relative to other currencies) from its early 2002 highs. Gold and commodity prices act like canaries in the monetary gold mine, warning of dollar debasement.

Crude oil prices are about one-third less than their 2008 highs, but orders of magnitude higher than they were 10 years ago, which not coincidentally was the latest high-water mark for the dollar. It's worth remembering that crude oil, commodity, and gold prices all began soaring very soon after Nixon decided to break the dollar's tie to gold in the early 1970s.

Real estate stands out as one of the very few tangible assets that are not even close to an all-time high. Commercial real estate, for example, is worth about the same today as it was when the dollar reached its peak in early 2002, and residential real estate, according to the Case Shiller property index, is worth only 15% more (though the cost of financing real estate is at an all-time low). In other words, the dollar is worth a lot more relative to real estate than it is relative to other currencies and commodities. That in turn suggests that real estate is the cheapest hedge against further dollar weakness.

Finally, corporate profits aren't worth very much in terms of dollars. Considering that PE ratios are 17% below their long-term average and the dollar is very close to its all-time lows, U.S. equities are practically on a fire sale in the eyes of foreign investors. A dollar of earnings has almost never been so cheap for the rest of the world, yet after-tax corporate profits today are at all-time highs, both nominally and relative to GDP. This has only one meaning: the market has almost no faith that the outlook for the U.S. economy will be anything but dismal. This reflects poorly on our monetary policy, which has the potential to greatly increase future inflation, and on our fiscal policy, since trillion-dollar-plus annual deficits and massive unfunded entitlement liabilities have the potential to significantly increase future tax burdens.

All of the above adds up to a very depressing message: the market thinks the U.S. sucks. However, it also confirms my repeated assertions that valuations are still extremely depressed. Conditions are terrible, even grim, but lots of bad news is priced into just about everything. If U.S. monetary and fiscal policy can move even modestly in a more positive/less negative direction in coming years, there is plenty of upside for equity prices.