How Soon Might the Dollar Hit Bottom?

April 29, 2011

Answering the above question starts with Fed policy.  At Wednesday’s press conference, Fed Chairman Bernanke showcased an impressive mastery of many policy issues and a blatant disregard for the weakening dollar that left financial market participants more convinced than ever that U.S. officials will take no action to stop its fall.  The Chairman insisted that pursuit of the Fed’s dual mandate of maximizing employment and preserving low and stable inflation is the best way that monetary authorities can promote medium-term dollar health.  This is an argument that subordinates dollar policy to domestic monetary policy, intrinsically ruling out intervention or raising interest rates to counter dollar depreciation if doing so would result in a less desirable mix of inflation and growth.  He reiterated the views that the incline of inflation stems from transitory commodity price strains and that growth continues to be less dynamic than wanted, but he defended quantitative policy stimulus as an appropriate step that put the economy on a better trajectory than it would have followed without the action.

The cause and effect connection between stronger growth and lower inflation on the one hand and a strong dollar on the other is debatable. The United States has enjoyed comparatively stronger growth than Europe or Japan for a couple of decades, and inflation has followed a secular decline since spiking in the 1970s.  The dollar nonetheless has seen its value eroded.

The dollar is extremely weak by many measures.  It’s getting close to its historic trade-weighted low set in April 2008.  This week’s trough of CHF 0.8644 constituted an all-time low against the Swiss franc, which is now trading 406% above its 1960s parity of 4.373 per dollar and 240% stronger than its post-1973 low of 2.937/USD in late February 1985.  Sterling is 61% stronger against the dollar now than in February 1985 even though the Bank of England’ key interest rate was then at 14%, 600 basis points above the Fed’s rate.  The Australian dollar and Chinese yuan are at a 28-year and 18-year peaks against the U.S. currency.  South American currencies like the Chilean peso and Brazilian real are also experiencing multi-year highs against the dollar.  Against the major traded currencies followed on this service, the dollar fell broadly this past week and across the board as well during the whole month of April.

Take the euro, which is the second most widely used currency.  Analysts expected it to sink sharply in 2011 under the strain of Europe’s sovereign debt crisis.  Instead, the dollar fell against the common European currency by 2.8% in December, 2.4% in January, 0.8% in February, and 2.8% in March.  The euro’s rise does not reflect mounting confidence toward Europe.  Britain’s economy didn’t grow at all between 3Q10 and 1Q11, and Euroland’s  festering fiscal and banking problems indeed went from bad to worse in April, with ten-year bond spreads versus German bunds widening in the two weeks between the 13th and 27th by 353,156 and 131 basis points in the cases of Greece, Ireland, and Portugal.  The dollar fell 2.0% against the euro this past week, by 4.6% in April, and by 20% from a 2010 high last June 7 of 1.1878 per euro to a low today of 1.4883.  The euro is worth 165% more now than its D-mark translation value in late February 1985.  The Fed’s benign neglect toward the weaker dollar has been matched by European monetary authorities.  The ECB has begun to raise rates, knowing that such action would probably drive the euro higher, and President Hildebrand of the Swiss National Bank today noted that Swiss domestic demand is growing vigorously in spite of the franc’s appreciation.

Just because officials in the United States take no overt action to end dollar depreciation doesn’t mean that an enduring trend reversal or temporary correction of its drop will not occur on its own. The eroding value of the dollar has been associated with other market trends that look potentially overdone.  One of these is the rise of U.S. and world share prices.  The DJIA index has climbed 30.5% since the dollar peaked against the euro on June 7, 2010.  The Dow, S&P 500, and Nasdaq are 96%, 102%, and 127% above their closing levels on March 9, 2009 and even above levels when the housing market first started to head south in the spring of 2006.  Precious metal prices and the cost of oil are also in the stratosphere.  If current conditions in equity and commodity markets constitute asset bubbles, a pretext may not be needed for trends to reverse, and the shift in dynamics accompanying such an event should lend support to the dollar.

Bernanke argued last Wednesday that the extent of policy ease depends on the size of the Fed’s balance sheet, not its rate of change, so terminating quantitative easing is unlikely to produce substantive responses by financial markets or the economy.  What if that’s an oversimplification?  If people believe that Fed policy has become less accommodative at the same time that Congress is taking steps to tighten fiscal policy, their economic behaviors will adapt to the expectation of less policy stimulus.  In the window between late 2009 as QE1 was winding down and Bernanke’s revelation at end-summer 2010 that a second round of quantitative monetary easing was under serious consideration, it’s a fact that the economy slowed, and the dollar strengthened. 

History seldom replicates itself exactly.  Too many variables exist for them all to align precisely the same way at two separated points in time.  The above discussion remains hypothetical.  Global policy cycles were much more synchronized last summer than now.  Dollar depreciation has been allowed to play out very far, and one would think that it will in fact require an act of policy design, not the spontaneity of market forces, to restore investor confidence in the dollar and slow the intensifying efforts of big dollar holders to diversify into the euro and other dollar alternatives.  That’s the factor over which dollar bulls need to be most concerned.  The U.S. Treasury market remains well-behaved.  A 10-year 3.30% yield is very low and indeed even below the year-to-date mean of 3.44%, let alone the 4.45% average level during the noughties decade.  Europe’s peripheral economies are in precarious danger because they cannot use currency depreciation to counteract the drag of mandated fiscal restraint and rising interest rates.  The United States is not so constrained and should take advantage of that extra flexibility.  It’s not a crisis if dollar depreciation isn’t creating collateral damage.  If there was any doubt, Bernanke’s responses to questions on the dollar telegraphed no sense of urgency about the dollar’s losses.

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


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