Monday, December 3, 2012

The dollar is so weak that it might be good news

No matter how you look at it, the dollar is very weak—very close to its all-time lows. If the value of the dollar says anything about the world's confidence in the U.S. economy, the message is quite pessimistic. The only good thing to be said is that there is a lot of bad news that is priced into the dollar. It might be tough for things to get much worse.

This chart, with data as of October 2012, is arguably the best measure of the value of the dollar vis a vis other currencies. It is trade-weighted and inflation-adjusted. The "Broad" measure uses a basket of over 100 currencies, while the "Major Currencies" index compares the dollar to 7 currencies: the Euro, Canadian dollar, Japanese yen, UK pound, Swiss franc, Australian dollar, and the Swedish krona.

What it says is that a dollar today buys less overseas than at almost any time in modern history. (Although the Fed's calculation starts in 1973, in the prior decade the dollar was on average about 10% higher.) The dollar is scraping the bottom of the barrel these days, no question.

A very weak dollar is very likely the result of weak demand for dollars (relative to other currencies) combined with a generous supply. Demand for dollars is weak because there are many causes for concern: the weakest recovery ever, the dismal outlook for growth, the fiscal cliff, the prospects for heavier regulatory burdens (e.g., Obamacare), and the prospect of trillion dollar deficits for as far as the eye can see.  The value of the dollar is also a function, of course, of Federal Reserve monetary policy. Since the dollars' peak in 2002, the Fed on average has been quite generous in its willingness to supply dollars, as evidenced by the length of time that real short-term interest rates have been negative.

The charts that follow show my attempt at estimating just how weak the dollar is against individual major currencies.

With all the problems in the Eurozone (e.g., recessions in many countries, extremely high unemployment, the threat of major sovereign defaults), and the non-negligible risk that those problems lead to the end of the Euro, it is telling that the Euro is still relatively strong—10-15% overvalued by my calculations—vis a vis the dollar. It shouldn't be hard for the dollar to beat the euro, but it hasn't been able to clear that very low bar.

The yen has been the strongest of all the major currencies for decades, thanks to very tight monetary policy and very low—and often negative—inflation. Recent weakness in the yen owes much to the Bank of Japan's renewed efforts to loosen monetary policy and stop deflation. Yet the yen continues to largely shrug off the fact that Japan's public sector deficit is still deep in double-digit territory, and the economy has posted very weak growth in recent years. Still, today the yen is only 40% overvalued against the dollar by my calculations. By comparison, it was 90% overvalued at its brief peak in 1995.

The pound remains overvalued—by about 20% according to my calculations—despite the dismal performance of the U.K. economy—worse even than that of the U.S.. Real GDP in the UK is still 3% below its pre-recession high, and growth has been mostly nonexistent for the past two years. Moreover, industrial production has not increased at all from its recession lows. Inflation in the UK has averaged 4% per year for the past three years. In a word, the UK suffers from outright stagflation. Again, it is telling that despite these gloomy conditions, the dollar is still relatively weak against the pound.

After decades of dismal performance relative to the US dollar, the Canadian dollar has almost never been as strong as it is today—about 30% overvalued vis a vis the US currency according to my calculations. Canada is riding a commodities boom, and its housing and financial markets have been much healthier than their US counterparts, thanks to the absence of housing subsidies and the relatively low level of government meddling in the housing market. Canada is even managing to reign in public sector spending, thanks to smart incentives that reward key bureaucrats for reducing spending. Stronger economic fundamentals have allowed the Bank of Canada to avoid slashing short-term rates to zero, thus giving the currency the added advantage of higher yields than can be found in the US.

Thanks largely to booming demand for its raw materials, the Australian economy has grown almost 3% per year over the past three years, and the Reserve Bank of Australia has not had the need to lower short-term rates to zero. With monetary policy arguably tighter than in any country save the possible exception of Japan, and with confidence in the economy still relatively strong, it is not surprising that the Aussie dollar is almost 57% overvalued vis a vis the US dollar—making it the strongest of all the major currencies relative to the dollar.

If there is any silver lining to the dark cloud that overshadows the US dollar, it is that market expectations are very pessimistic. Lots of bad news is priced in. It's even possible that the market is braced for the news that the US is going to fall off the so-called "fiscal cliff." Although I hesitate to say it, it might even be the case that if Washington fails to come to an agreement by the end of the year, and taxes shoot up and spending sequesters kick in, the result could be less bad than is already expected.

After all, we've had many years now of reckless fiscal policy: almost four years without a budget being passed by the Senate, trillion-dollar deficits, a federal debt that has more than doubled as a % of GDP in the past five years, and reckless management of the public debt that has shortened Treasury maturities to an all-time low at the precise time that interest rates have also reached all-time lows. If Congress and the president finally run up against some limits, however arbitrary they may be, this might not be such a bad thing after all.

I should add that I'm not at all optimistic that we'll avoid the fiscal cliff. Obama is dug in on his demand for sharply higher tax rates on the rich, even though that doesn't stand a prayer of plugging the gaping federal deficit or strengthening an already weak economy. The Republicans stand on firmer ground, insisting on not raising taxes for anyone while at the same time making a credible effort to rein in the growth of entitlement spending, since that avoids creating negative incentives for growth; after all, economic growth is the only thing that holds out the promise of significantly reducing future deficits. Obama seems determined to risk a cliff fall, in the belief that he can pin all the blame on the Republicans and thus strengthen his hand in the future. But does he really want to cripple the economy just for personal gain, threatening his last chance at creating a growth and prosperity legacy?

I wish I had a crystal ball. In the meantime, my only source of comfort is all the pessimism that is to be found in market prices.


William said...

I truly believe the best possible solution to the US fiscal deficits and national debt is to go onto the "fiscal slope" - its not really a cliff. It's a trajectory which will decrease government spending by $3 trillion over ten years. In other words, the US government over ten years would spend $41 trillion instead of a projected $44 trillion.

It can't be all that bad and the cuts in spending will be in the right places in my view. Going back to the already low Clinton era tax rates also can't be all that bad.

I predict the market will rally on that good news.

Public Library said...

My trade continues to be long +CAD/-JPY. I just feel like at some point in the next 10 years JPY is going to blow up. And whe it does, it will happen lightning quick.

Gloeschi said...

"Good news is good, and bad news is priced in"

Scott Grannis, Blogger, quote found in every single one of his posts.

Benjamin Cole said...

Interesting post.

Still, the USA economy is performing better than Europe's (where the ECB targets 0 percent inflation) and Japan (where, until recently, 0 percent was targeted).

And not as well at China (where the People's Bank of China targets a 4 percent ceiling inflation rate).

Many parts of the both the Japanese and Euro economies have actually been liberalized in the last 20 years. Still, they struggle.

China is a commie-run mess. But it prospers.


Maybe a more-expansionarty monetary policy is needed, and that would bring even an even cheaper dollar.

Fine by me.

jeff said...

Perhaps a dumb question but when you say the weak dollar is a result of a generous supply - how or what measure is making you conclude this?

Scott Grannis said...

Jeff: I see lots of evidence of a generous supply of dollars: negative real interest rates, gigantic increases in bank reserves, 8-9% growth in M2, 9-10% growth in dollar currency, and $1700 gold (I infer that gold is up because the supply of dollars exceeds demand). You could probably add very low swap spreads to the list as well, since they reflect abundant liquidity conditions.