How strong is the dollar?

This chart is arguably the best way to look at the relative strength or weakness of the dollar. It's calculated by the Fed, and adjusted for trade weights and inflation. There are two versions: one using a broad basket of currencies, and the other using just seven major currencies (euro, Can$, yen, pound, swiss franc, aussie$, and swedish krona). The most recent data, released today, shows that the dollar is trading about 2-12% above its long-term average values against these baskets of currencies. I've used a log scale for the y-axis in order to better reflect the degree to which the dollar is above or below its long-term average.

Interest rate spreads drive the dollar

With U.S. short-term rates rising and Eurozone rates falling deep into negative territory it's not surprising that the dollar has been gaining against the Euro. Behind these moves is a U.S. economy that appears healthier than the Eurozone economy, and that in turn conditions markets to expect very different monetary policy conditions for the foreseeable future. The dollar's strength to date is salutary and not overdone, so it doesn't present a problem for the U.S. economy. (Question to those who worry about the strong dollar: If a stronger economy is what is driving a stronger dollar, why should a stronger dollar be bad for the economy?)

The chart above compares 2-yr Treasury yields with 2-yr German yields. They have diverging for almost two years now, driven by the growing perception that the Fed would raise rates sooner than the ECB, and more recently, by the ECB's professed willingness to actively pursue easier monetary policy for the foreseeable future.

The chart above makes it clear that interest rate differentials between the U.S. and the Eurozone (blue line) go hand in hand with changes in the Euro/dollar exchange rate (red line). The dollar has strengthened vis a vis the Euro in line with more attractive U.S. interest rates.

The chart above compares the dollar value of the Euro against my calculation of the dollar's Purchasing Power Parity against the Euro (green line), which can be thought of as the exchange rate that would result in prices in the Eurozone being generally comparable to prices in the U.S. By my calculations, the dollar is almost 10% above its PPP value against the Euro, which means that U.S. tourists to the Eurozone should find that things are a bit cheaper there. It's nice to have a strong dollar, and it's not strong enough at current levels to worry about.

Bond market embraces higher short rates

We're now two weeks away from the December FOMC meeting, when it is widely expected—and feared—that the Fed will lift short-term interest rates for the first time since mid-2004. It's not yet a slam dunk, given today's weak ISM manufacturing report, but market pricing implies a 70% probability of a move, and short-term rates are already rising in anticipation. The bond market is doing its best to give the Fed the "all clear," and the stock market looks to be in agreement. This is great news.

The two charts above put the Fed's upcoming move into historical context. The decline in interest rates which began 34 years ago is now coming to an end. 2-yr Treasury yields, which are equivalent to the market's expectation for the average Federal funds rate over the next two years, are now 0.9%, up from an all-time low of 0.16% in September 2011. They haven't been this high for over 5 years. 10-yr Treasury yields are now 2.15%, up some 75 bps from their all-time low of 1.39% in July 2012.

There's nothing unusual or scary about the current slope of the yield curve; it simply means that the market fully expects higher rates, but not so high as to threaten growth. The time to worry is when the yield curve becomes flat or negative, and we are probably years away from that. No one expects the Fed's upcoming or subsequent moves to threaten anything.

As the chart above shows, 3-mo T-bill yields have jumped some 20 bps in the past six weeks, after hugging zero for several years. Market participants are no doubt deciding that the yields available on alternatives—such as bank reserves and 3-mo LIBOR—are more attractive than earning nothing on bills: swapping out of bills into the alternatives is the logical maneuver. It's encouraging to see the price of the world's premier safe asset fall, since that suggests that the economic and financial market fundamentals have improved on the margin. Expect to see money market rates in general moving higher. Finally.

It's also encouraging to see that the recent rise in T-bill yields has been associated with a decline in the TED spread (the difference between the yield on 3-mo LIBOR and 3-mo T-bills). This spread has always been a good indicator of financial market stress. The current spread, about 20 bps, is almost exactly at the level you would expect to see during periods of normalcy. It's narrowed mainly because LIBOR yields have risen less the T-bill yields. As such, it reflects the dynamic of rising interest rate expectations, and not any deterioration of the fundamentals.