No Dollar Bubble

December 7, 2009

If the dollar closed 2009 at its present levels, it will have dropped in six of the past eight calendar years against both the euro and yen, and 2005 would remain the only year since 2001 in which the U.S. currency rose against both the Japanese and euro area currencies.  The dollar is 39.9% weaker than its end-2001 level against the euro and is down 32.0% relative to the yen.

The better dollar tone on Fridayand swift drop in gold has market participants wondering if a major dollar reversal might be starting.  I do not think so.  Four economic fundamentals argue against a prolonged uptrend.  First, a rise in the Fed funds rate probably lies too far away for an enduring and anticipatory dollar rise now to bridge the time remaining until Fed tightening in fact begins.  Moreover, if other central banks match the Fed or are more aggressive in moving to a more neutral policy stance, Fed tightening may not lift the dollar even after such is under way.  Check out the dollar in 1994 when the Fed lifted its rates often and significantly.  Second, the Obama presidency has underperformed expectations.  Washington politics have been more partisan than hoped, the U.S. economy got worse in some respects, and Obama’s policy predispositions on many key fronts such as Afghanistan, health care, and financial reform do not resonate with the wishes of an American majority.  Third, the U.S. retains structural imbalances that will not be repaired if the dollar climbs sharply.  There is very high unemployment yet also severe fiscal problems, which investors fear may seed future inflation.  Finally, the world economy does not appear to be returning to the crisis conditions of a year ago that were associated with a stampeded into U.S. Treasuries and a rising dollar.  The recovery of global activity may flounder early next year as fiscal support lessens, but deterioration need to be very serious to recreate another bout of market-changing risk aversion.

Even without a valid fundamental economic pretext, it’s possible to achieve a major reversal of the dollar if its weak levels represent an inflated bubble for its rivals that have been bid upward.  Europeans have grumbled about the pricey euro, and Japanese officials have protested recent market developments even more vociferously.  This week’s issue of Foreign Exchange Insights argues that the yen is fast approaching a breaking point and that the currency is likely to be conspicuously weaker next decade.  However, I hold that view based on Japanese fundamentals, not any notion of a yen bubble.  Asset bubbles tend to inflate at a quickening pace before popping, but the dollar’s losses in 2009 and 2008 were mild by comparison with earlier years this decade.  In yearend to yearend terms, the dollar actually rose 4.5% against the euro last year and could still very conceivably close with a net advance against the yen in 2009.  The table below shows the dollar’s yearend to yearend changes against the euro and yen since 2002 including year-to-date movements in 2009.

Dollar Against Euro Yen
2002 -15.2% -9.7%
2003 -16.6% -9.6%
2004 -7.3% -4.4%
2005 +14.8% +14.9%
2006 -10.4% +1.0%
2007 -9.7% -6.4%
2008 +4.5% -18.7
2009 -5.7% -1.3%

Copyright Larry Greenberg 2009.  All rights reserved.  No secondary distribution without express permission.

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