Tuesday, May 3, 2011

Reflections on the dollar's weakness

With the Fed's latest data release, it's official: in inflation-adjusted and trade-weighted terms (arguably the best way to measure the dollar's true purchasing power overseas), the dollar is now weaker than it has ever been.

Against a relatively small basket of major currencies (above chart), and not adjusted for inflation differentials, the dollar has yet to hit new all-time lows, but it's very close.

What does the dollar's unprecedented weakness mean? A lot of things:

It reflects the world's deep mistrust of our monetary and fiscal policies. In a sense, the dollar's value is akin to the price that foreigners are willing to pay to gain access and exposure to the U.S. economy. The very weak dollar is a sign that the U.S. is a very unattractive place to do business these days.

The Fed is supplying more dollars to the world than the world wants to hold. As a corollary, the Fed is setting U.S. interest rates at a level that is lower than they should be to balance the world's demand for dollars with the supply of dollars.

U.S. exporters may get a temporary boost, since a cheap dollar makes it easier for them to undercut foreign competitors. But the cheap dollar will tend to boost the price of all imported goods, and that in turn will increase the cost of living for everyone. Eventually, higher inflation will erode whatever advantage exporters might enjoy today. You can't devalue your way to prosperity.

U.S. tourists will find that most overseas destinations are extremely expensive; combined with expensive energy, this is likely to curtail many summer travel plans.

Foreign tourists will find that the U.S. is one of the cheapest destinations in the world; this is likely to boost the U.S. tourism industry.

Foreign holders of trillions of dollars of U.S. debt are losing money daily as the dollar declines against their currencies. Over the past year, for example, the Chinese yuan has appreciated by 5% against the dollar, thus reducing the value of China's Treasury holdings by 5%; that's roughly equivalent to two years' worth of interest payments. China doesn't have much of an alternative, though, since unloading a significant portion of its U.S. debt holdings would likely depress the dollar even more. Foreigners in aggregate have huge exposure to the dollar (the flip side of our multi-year trade deficits is a multi-year inflow of foreign capital); so huge, in fact, that they have little alternative but to grin and bear it.

If foreigners were to sell a significant portion of their U.S. holdings, they would not only lock in huge losses, but they would also have to find something here on which to spend the dollars they no longer want. Any net capital outflow would perforce require a net trade surplus. A mass liquidation of U.S. security holdings by foreigners could translate into a gigantic increase in U.S. exports. Alternatively, a significant portion of any mass liquidation of Treasuries by foreigners could find its way into our equity and property markets. Treasuries are trading a unusually high valuations (i.e., very low interest rates), while equities are not overvalued (e.g., PE ratios are below average), so swapping out of Treasuries and into stocks and real estate might make a lot of sense to many foreign investors. To the extent this happens, Treasury yields and equity prices might rise simultaneously.

Foreign investors are finding that U.S. real estate is very cheap. Since the peak of the housing market in early 2006, prices have fallen by about 30% according to the Case Shiller data, while the dollar has declined by about 15%. Combined, that has reduced the effective price of the typical U.S. home by 40% in the eyes of foreign investors. Foreign demand for U.S. real estate likely is playing an important role in stabilizing the U.S. property market.

With the dollar trading at all-time lows, a decision to sell the dollar here requires a firm conviction that the bad news that is already out there (e.g., trillion-dollar deficits, and a massive expansion of bank reserves that could fuel a huge increase in inflation) is going to get even worse—not only are things as bad as they've ever been, but we ain't seen nothin' yet.

With the dollar plumbing all-time lows almost daily, it is no secret that the outlook is grim. Dollar sentiment is extremely depressed. The dollar could therefore benefit from any indication that conditions are not as bad as everyone thinks. The mere absence of bad news could be very good news for the dollar. If the news turns positive (e.g., Congress finds a way to restore fiscal sanity without big tax hikes, and/or the Fed raises interest rates convincingly) then the dollar could have massive upside potential.

But as my mentor Art Laffer taught me, fiat currencies—unlike gold and real estate—have no intrinsic value. They can (and many do) decline forever.

Feel free to add more reflections in the comments.


brodero said...

Forgotten is all this wailing and gnashing of teeth about the dollar..is that the US represents 43% of
the world'd military expenditures
second is China at 7%..3rd is UK
at 4%...the dollar is more than
trade..it represents preeminent
military power too....

Benjamin Cole said...

The dollar was virtually this low in 2008. I don't recall all the alarm bells going off then. Nor did we see an inflationary spike--in fact in 2009-2010 we hit deflation.

US travel spots will benefit from good present exchange rate for the dollar; US manufacturers will benefit; I know US architects are selling services overseas every heavily, so I assume our service sector will do well also. Jeez, what not to like?

The specter of inflation is raised. But with worker productivity surging (and unit labor costs falling), and real estate comatose, this specter has both hands tied behind its back.

Add on, the commodities rally may be dead.

Some say that 1 percent of 1Q GDP growth was due to exports. We only had 1.4 percent GDP growth in 1Q. Sheesh, take away exports and what do you get?

Japan's yen has appreciated for decades. Their economy is in the perennial toilet. The "strong" yen has not worked.

We are close to doing a Japan now. Our real estate markets are dead in the water. Our DJIA is below 1999 levels. Unit labor costs are falling. Core inflation rates just above zero.

Hopefully, Bernanke will follow a different path from the Bank of Japan.

Public Library said...

"Artificially lowering interest rates wipes out capital formation and gives the incentive for capital to (1) hoard, (2) flee or (3) speculate."

The exact opposite of what we want...

Benjamin Cole said...

A serious question: What is the intrinsic value of gold?

I think I understand the answer in regards to real estate--you can live on it, rent it out, farm, use it as factory space etc.

But gold? It has some value in industrial applications, I grant that.

But intrinsic value seems attached to its use as jewelery, a value now determined in India and China (largely). Boy, that could change in a hurry, no? Or decline for 20 years?

Public Library said...

Over the last few thousand years, you could easily swap gold for wood to build a house.

However, if gold is controlled by the government, then it is the same as fiat currency. Rome clipped coins to achieve their demise. Bernanke just hits the print button nowadays.

Benjamin Cole said...


Okay, gold has had a great rally.

OTOH, gold sank in value for decades after 1980. The house you could buy with 100 ounces of gold would shrink or balloon over the years.

Gold seems to have no intrinsic value. Ordinary government bonds have much less volatility in real purchasing power, especially TIPS bonds.

Public Library said...

Nominals and TIPS rely on the creditworthiness of the government. We are entering a transition phase in the credibility of sovereigns.

Choose wisely.

Lori said...

Other than a coin shop, take a '64 Kennedy silver half dollar to a gas station.

How much fuel do you they will exchange for it?

Benjamin Cole said...

Believe it or not, I found a real silver dollar in my change the other day.

William said...

My perspective is in 1967 the USAF sent me to West Germany. During my entire 4 years there, one German Mark bought $0.25 - a US Quarter. Today the German Mark equivalent - the Euro - buys $1.47. With fluctuations, the trend of the US Dollars has been down for 44 years - for many reasons.

I am not a "technician", BUT if we asked a "technician" what he thought about Mr. Grannis' chart of the Real Broad Dollar Index, I think that he would say that there is no underlieing support level for the US Dollar. No one knows where the bottom is. "It has broken all support".

Furthermore, recently the BRIC countries met and discussed how they might trade with each other without using US Dollars. Not only Iran but recently Russia is asking customers to pay for their massive oil exports in a basket of currencies. As Mr. Grannis pointed out China is letting it's Yuan rise more rapidly in order to help curb inflation: meaning the US Dollar is depreciating versus the Yuan. In fact against the Euro, the US Dollar has fallen from its most recent high of 1.25 to the present 1.47 US Dollars for one Euro - a 16% decline for a European investor holding US Dollar assets.

More and more countries do not like being at the mercy of the US Federal Reserve setting interest rate policy which is what happens when they "peg" to the US Dollar.

The world's opinion of the USA is changing negatively and it is reflected in the US currency.

Public Library said...

Thats the point Lori. You would take it to a coin shop and exchange it for whatever currency you wanted in whatever country you were located.

While your coins value is rising as you travel west to east, taking that fiat dollar on the road-trip will generate pain.

Your one-liners always fail to pack real punch. Slow-down on the rapid fire responses. This is a blog, not your 140 character twitter stream.

William said...

I like Lori's pithy comments ;~)

TradingStrategyLetter - Weekly Summary said...

1964 Kennedy Silver Half Dollar Value:

.90 silver
.10 copper
12.5 grams

Melt Value of silver : $14.337625


a 2800% increase (gain)
in value since 1964 vs drop (loss) of real purchasing power value of currency of 50-60% since 1964

Numusmatic Value $15-46 depending on condition.

TradingStrategyLetter - Weekly Summary said...

Half Dollar Gas Calculation:

.50 x 3% (savings account rate) x 45 years = $1.89 - or - one half gallon of unleaded gas at current pump prices

Purchase of US Kennedy Half Dollar Silver content .90)coin = current melt value of $14.33 (minimum) - or - 3.5825 gallons of unleaded gas at current pump prices

Conclusion - Since 1964 approx 650%
more unleaded gas could be purchased today if you saved a US Kennedy Silver content Half Dollar as opposed to banking the .50 in a savings account.

Stone Glasgow said...

Fiat currencies have intrinsic value because they can always be used to pay off bank loans at a fixed exchange rate. If the dollar inflates to zero tomorrow, you can still walk into the bank with worthless cash and pay off the loan, taking ownership of your home.