Dollar’s Down…. So What Else is New?

March 31, 2011

It’s been a poor quarter for the dollar.  The dollar accrued losses of 5.5% against the euro, 2.69% against sterling, 2.7% relative to the Canadian dollar, 1.4% against the Swiss franc, 0.8% vis-a-vis the Australian dollar and 0.6% against the yuan.  The currencies of Japan and New Zealand netted gains against the dollar, but each of those countries suffered devastating earthquakes in the quarter and now face years of rebuilding.  Japanese officials have been intervening to counter yen strength, and New Zealand monetary authorities cut their key rate by a greater-than-expected 50 basis points back to its cyclical low.

The dollar has experienced much worse quarters than this last one, but this isn’t a zero-sum game case of win a few and then lose a few.  Fact is that the dollar has tasted defeat a lot more often than victory.  The pattern of chronic dollar erosion can be observed in the following table, which expresses the U.S. currency’s movement in sequential ten-year intervals:  from end-March 1971 to end-March 1981, end-March 1981 to end-March 1991, end-March 1991 to end-March 2001, and end-March 2001 to today’s closing levels.  The cumulative changes for each period are expressed in annualized percent per annum terms.  Dollar relationships against its two main rivals, the euro and yen, are studied, and as a proxy for the euro prior to 1999, the D-mark was substituted.

% per annum 3/71-3/81 3/81-3/91 3/91-3/01 3/01-3/11
Dollar-euro (DEM) -5.3% -2.2% +2.6% -4.6%
Dollar-yen -5.1% -4.0% -1.1% -4.0%

 

Using the same raw data, a second table constructed bellow illustrates the dollar’s tale of chronic erosion even better.  It presents the percent per annum rate of dollar depreciation against the euro (mark) and yen over the past 10 years, 20 years, 30 years and 40 years. Whichever of these lengths of time one examines, the dollar has dropped at a rate of at least one percent per annum against the yen and dominant European currency.   Looking at only the past ten years, a span when the euro was in existence throughout, the rate of dollar depreciation has exceeded 4.0% per annum against each of its chief rivals.

% p.a. Last 10 Yrs Last 20 Yrs Last 30 Yrs Last 40 Yrs
Dollar-euro (DEM) -4.6% -1.0% -1.4% -2.4%
Dollar-yen -4.1% -2.6% -3.1% -3.6%

 

QE2 has been the driving force of dollar weakness over the past seven months.  Quantitative easing also boosts equity share prices and commodity costs.  When the Fed pump-feeds a deleveraging economy, the liquidity has to go someplace other than into bank loans, so other currencies, the stock market, bonds, and commodities all got a piece of the action.  During the first round of quantitative easing, announced in mid-December 2008 and mostly completed by end-March 2010, oil prices soared 92%, and the Nasdaq, S&P 500 and Dow went up 55%, 29%, and 25%.  The dollar also rose modestly on balance in those fifteen months, gaining 3.9% against the yen and 1.8% versus the euro.  In 2010 without the prospect of Fed force-feeding between end-March and Bernanke’s Jackson Hole speech some five months later that heralded QE2, oil prices retreated 10.3%, and the Nasdaq, S&P, and Dow fell back by 10.2%, 8.9%, and 6.5%.  The dollar climbed 6.4% against the euro, almost four times more than while QE1 was in play, but fell 8.9% against the yen.  Since Bernanke went public with QE2 plans, oil prices have risen some 42%, and all three stock indices rose over 20%.  The dollar, however, sank 10.1% against the euro and 2.4% relative to the yen.

Considering the deteriorating fiscal circumstances in Europe and the danger that such poses to the institutions that bind so many countries together in economic and monetary union, the dollar’s weakness against the euro since last August underscores what a powerful currency negative quantitative easing has been and by inference suggests a coming period of greater dollar buoyancy if, as seems probable, quantitative easing is stopped in June or aborted short of its $600 billion limit.  In the first quarter of 2010, investors stood vigil for the coming ECB interest rate hike.  In the second quarter, attention will shift to the Fed, but markets also will be on guard for a second ECB tightening.  This may be enough change to lift the dollar, but long-term trends point only to a temporary respite for U.S. currency’s erosion.

Relative strong U.S. economic growth and declining inflation didn’t protect the dollar through the years.  Real GDP rose 3.2% per annum between 1Q71 and 1Q81, 2.8% per annum between 1Q81 and 1Q91, 3.6% per annum between 1Q91 and 1Q01 and 1.8% per annum over the last ten years.  True, the dollar performed better when the economy expanded 3.6% in the penultimate ten years than in the last and most recent decade when growth was only half as strong.  But 3.6% per annum wasn’t sustainable, and allowing such to happen eventually took the U.S. and global economies down a deeply regrettable path.  The dollar also fell in the long run in spite of a pronounced deceleration of U.S. CPI inflation from 8.3% per annum between 1Q71 and 1Q81 to 4.3% per annum between 1Q81 and 1Q91, 2.7% per annum between 1Q91 and 1Q01 and 2.3% per annum over the last ten years.  Many analysts now fear that excessively accommodative monetary policy has laid the seeds for a trend reversal in inflation that will prove secular as well as cyclical.  The last secular intensification of price pressure in the 1970s put serious downward pressure on the dollar.

Several explanations have been offered for the dollar’s long-term decline.  One is the chronic U.S. current account deficit, which has persisted in spite of massive nominal depreciation over the last four decades and indications of substantial under-valuation against several other currencies at the moment.  Another involves periodic bouts of benign neglect by Treasury bureaucrats and elected politicians, who are tempted to coax a little more growth out of GDP and jobs by letting the dollar slip-slide from time to time.  A third weight on the dollar is the dual mandate of the Federal Reserve, which puts the maximization of employment on an equal footing with safeguarding the internal and external value of the nation’s money.  Most other central banks, including the ECB, are instead single-mindedly obligated to preserve low, predictable, and consistent inflation, so they naturally would tend to respond more quickly to deviations.

All of the above reasons hold considerable merit but do not fully explain why the dollar seems to lose ground invariably if one simply waits long enough.  If one thinks of a country’s money as embodying the present value of the nation’s future standard of living in relative terms vis-a-vis prospects in other nations, it becomes intuitive that the dollar should lose ground from generation to generation.  Why shouldn’t the dollar fall if the pinnacle of its combined military, economic, and cultural leadership was achieved several decades ago and is unlikely to be seen at such a supreme level again?  The fixed dollar exchange rates of 1950-1971 reflected the ravages of war in Asia and Europe.  Gaps in standards of living are now being narrowed not only among developed countries but with the rapidly emerging economies as well.  The United States has better demographic trends than most rich countries.  But it is getting beat in education, in the application of certain technologies of the future, in infrastructure upkeep, and in preparing for environmental change.  Moreover, the United States is saddled with unique military responsibilities that divert valuable resources into unproductive areas, and its people are unwilling to change a healthcare system that consumes a much bigger slice of national income than other countries do for similar results.  U.S. presidents from both parties are fond to say that America’s best days are yet to come.  It that proves true, the dollar will indeed rise secularly.  But clearly the dollar’s trend since 1950 suggests that world financial market investors are pricing in a different outcome.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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