Thursday, January 22, 2015

King dollar comeback

It was just over three years ago that the dollar hit an all-time low against most of the world's currencies. Since then it has come roaring back, especially in the past several months. Gains have been uneven—huge gains against the yen, but not much against the pound, for example—and on balance the gains have simply restored the dollar to something close to its average value since the early 1970s. These gains may continue and could become problematic if they are excessive and rapid—strong and stable currencies are the healthiest—but for now it's appropriate to cheer the return of King dollar. 

The dollar has gained 22% against the euro since last March, and it is up 40% from its all-time low against the euro in 2008. The green line represents my estimate of the euro/dollar purchasing power parity: the level of the euro that would make prices for goods and services in the Eurozone roughly comparable to those same prices in the U.S. At today's exchange rate, American tourists in the Eurozone are likely to come away thinking that prices over there are about the same as they are here. Changes in the level of the PPP exchange rate are driven by changes in relative inflation rates. The upward slope of the green line over the decades means that inflation has been higher in the U.S. than it has in Europe.

The Australian dollar soared coming out of the Great Recession, boosted by soaring commodity prices. A lot of that has been reverse in the past several years as commodity prices have weakened. Still, the Aussie dollar remains quite strong vis a vis the dollar, according to my PPP calculations.

Like the Aussie dollar, the Canadian dollar has been on a roller coaster ride, driven by swings in commodity prices. The dollar has gained 30% vis a vis the Canadian dollar since its low of 0.95 in 2011. Prices in the U.S. and Canada are approaching parity these days.

The British pound has been relatively stable against the dollar, on balance, for the past six years. However, higher inflation in the U.K. should tend to depress the value of the pound over time. The U.K. is still somewhat expensive for U.S. tourists.

The dollar has gained an impressive 55% against the yen in the past three years, rising from a low of 76 to 118 today, thanks largely to the Bank of Japan's aggressive monetary easing. The yen had been appreciating against almost all other currencies for decades, and had reached a very expensive level. With the yen now more "normally" priced, manufacturers and exporters should find some relief. But the economy is not likely to strengthen meaningfully unless and until fiscal policy becomes more growth-friendly.

Using the Fed's Real Trade-Weighted Dollar Index (based on the latest reading as of the end of November), I estimate that the dollar today has gained about 30% against a basket of major currencies in the past three years. This puts it about 5% or so above its average since 1973. That's an impressive comeback in three years, and it owes a lot to the fact that the U.S. economy—despite suffering  its weakest recovery ever—is arguably the strongest of all developed countries.


Benjamin Cole said...

I suspect we may see a fall in the value of the Chinese yuan (renminbi) in the next few years. In fact the whole China story is beginning to smell fishier and fishier. I suspect the People's Bank of China will be forced forced to inflate, and devalue the yuan thereby.

The Fed must show expansionist resolve, or we could see recession and deflation imported into the USA.

Yesteryear's central bank war was on inflation. They won.

Today's war? I suspect deflation and recession.

Can central banks adjust? Not sure.

Public agencies tend to ossify, self-exalt. The Fed is encrusted, hoary, self-reverential. They would have been run out of business long ago in the private sector.

The risk is another recession (for a reason we cannot see now, just like all recessions) and then an intractable deflation, as the Fed will be loath to go back to QE.

Let's hope for the best, and prepare for the worst.

Grechster said...

I'm somewhat encouraged by the action in the gold price. It has been pretty stable for the last 1.5 years, at least in US dollars. The vacillations are a little high for my liking but the price has been stable. I too don't have great confidence that the Fed will get things right. But the last 1.5 years suggest they're not asleep at the switch...

William said...

Venezuela is Down to its Last Banker: China

"Low oil prices are shattering Venezuela's economy. The government in Caracas acknowledged in December that it's in recession. Venezuela's inflation rate, at 63.6 percent, is the highest in the Americas. Even the most basic consumer goods have ceased to be available, and visitors to the country who spoke to a CNBC reporter in neighboring Colombia this weekend reported people in Caracas using the local currency's smallest notes in place of toilet paper....

"The going price of Venezuela's oil exports tumbled by about half to $41.33 a barrel this week after peaking last June, according to Venezuela's Ministry of Petroleum and Mining. In order to balance its budget, Venezuela needs oil prices of at least $100 a barrel, according to the Peterson Institute for International Economics....

"It seems China remains committed to the OPEC nation, at least according to Venezuela's President Nicolás Maduro, who announced in early January that China had pledged another $20 billion in financing....Since 2007, China has lent Venezuela more than $45 billion, of which an estimated $30 billion has been paid back in oil shipments, according Rodriguez.

William said...

WSJ: China’s Yuan Fell Sharply Monday!

"China’s yuan fell sharply Monday to its weakest level in seven months, pushed lower by the central bank as Beijing adds to a host of measures aimed at spurring growth.

The People’s Bank of China set the morning reference rate—which typically sets the daily direction—weaker, with traders then pushing the yuan down to the closest it has ever been to the weak side of its 2% daily trading band. The band was widened in March last year.

China’s move comes as many other large economies seek to boost growth with weaker currencies. The European Central Bank last week announced larger-than-expected stimulus measures, which sent the euro tumbling to its lowest levels in over 11 years, while emerging-market giant India has also surprised markets with an interest-rate cut this month."
Panelist on Barron's Round Table agreed that the worst thing that could happen in the world was for China to devalue that Yuan. No doubt it is in response to Japan's sharp devaluation which pressured Europe to value. The dominoes are falling as major economies attempt to compete by devaluing their currencies.


Steve Fulton said...

Scott, I'd be interested in your thoughts on the following. If total S&P profits are around $875-$900B and there is $2.1 Trillion in earnings held overseas (which I believe must be held as invested abroad indefinitely so I'm assuming that these earnings are held in some currency other than dollars) does this mean that the fortune 500 just lost $400B or roughly 1/2 a years earnings in the latest dollar move? And that doesn't count translation and transaction losses that could be just as large.

Scott Grannis said...

Steve: you raise an important point. The dollar is up some 17% in the past 7 months, which suggests that the dollar value of foreign earnings might have fallen as much as 15%.

However, there are a variety of considerations that substantial mitigate the damage of a strong dollar. For one, foreign earnings held overseas do not have to be held in non-dollar currencies. It's a safe bet that a substantial portion of the non-repatriated profits of US corporations are held in US dollars by a foreign-domiciled subsidiary and reinvested in US securities. Profits generated offshore can be converted to dollars and invested onshore even though they are not "repatriated" from a legal standpoint.

Two, US corporations can and do hedge at least some portion of their forex exposure.

Three, it is now cheaper for US corporations to purchase things overseas, thus lowering their costs in general. The stronger dollar has given us roughly a 10% decline in industrial commodity prices in the past 8-9 months, for example.

Four, the Chinese yuan, which contributes importantly to the bottom line of many large corporations (think AAPL), today is unchanged vs. its value last June.

The stronger dollar undoubtedly serves to weaken the overall earnings of US corporations, but it is not necessarily a serious problem.

Scott Grannis said...

Re: Chinese yuan. I think the press has been exaggerating the yuan's recent weakness. The way I see it, the yuan is no longer appreciating vis a vis the dollar. It's worth the same today as it was last June, when the dollar started appreciating against most other currencies.

Benjamin Cole said...

Watch the yuan. Carry-trade reversing flow. PBoC trying to peg yuan, but see Swiss for how that works.
Yuan bust? Remember Thailand baht 1997?
Capital flight from China already underway.
The CCP still runs China.
This could be a debacle.

Steve Fulton said...

Scott, it was interesting to look at Caterpillar's earnings. They are a pretty decent non tech global US based company. Basically all of their earnings shortfall came from currency (at least that's how it was presented in the earnings release). I've also long held that volatility always starts in the currency market and then spills over to other markets. Well we have the currency vol, so where is that volatility likely to spill? I would say not the rates market, but more likely the equity market.

Scott Grannis said...

Hi Steve: I follow you, but: equity vol is already up to 20+ and Treasury prices are on the moon. Currency and related worries seems to be driving both. This could get worse, of course. But the one thing that is very different these days is the zero yield on cash coupled with much higher yields on anything non-Treasury. The earnings yield on the S&P 500 is now 5.7%, which towers over the 1.7% yield on the 10-yr Treasury. You've got to be really bearish to exit equities.

Meanwhile, we are seeing a supply response in the oil field (rig count down 15% in the past six weeks), and swap spreads are at normal levels everywhere. Oil is not going to zero, since already it is having an impact on the economy (less drilling, more consuming). Cheap oil has to be a positive for global growth. What's not to like, outside of the oil patch?