For Better or Worse, Dollar and Stocks Married in an Inverse Relationship
May 13, 2011
The dollar and global share prices tangoed widely and in inverse relation to one another this past week, highlighting a pattern that has been observed much of the time since the financial crisis began. By 16:00 GMT on Friday, the dollar had booked net gains of a little more than 1.0% against the euro, sterling, Swiss franc and Australian dollars and had gains of around 0.5% against the Canadian and New Zealand dollars. It remains unclear whether foreign exchange or equities are the lead dancer, suggesting that they in fact are each reacting simultaneously to independent factors rather than cueing off the other.
The above relationship casts great doubt on whether a stronger dollar is in fact in America’s or the world’s best interest. It would be more optimal if the dollar were to stabilize at or only slightly below present levels than were it to keep rising. If the dollar corrects significantly upward, stock markets, which closed in America yesterday with a 22-month gain of about 96% would become very susceptible to a substantial downward correction that in conjunction with fiscal restraint and the end of the Fed’s quantitative easing could put the economic recovery in jeopardy. This logic runs counter to the view of many analysts, who argue that the sinking dollar is feeding inflation and putting America on a possible path to an expansion-killing bond market debacle. The Fed has a very difficult road to navigate, with no obvious win-win options.
From a technical standpoint, a downward correction of EUR/USD seems overdue. During the past ten years, this most significant of currency relationships traded below parity just 16% of the time and under $1.20 for just 26% of it. By contrast, quotes stronger than $1.40 as observed over the past two months occurred just 18% of the time, and those above $1.50 only for about 6% of the decade. The euro’s comfort zone lies between $1.20 and $1.40, where it traded in a $1.20-1.30 range 34% of the time and between $1.30 and $1.40 during another 22% block of the ten-year period. The mean value of $1.2456 for the entire ten years represents a 13.6% recovery of the greenback from its present level.
Mansoor Mohi-uddin of UBS penned a bullish dollar op-ed article in the May 11 Financial Times that makes several arguments for why the dollar should strengthen over the balance of 2011. My reservations against his and other strong dollar projections is that the positive factors that are cited are ones that have been ever-present more time than not for a considerably long period. There’s nothing new happening.
- U.S. Treasury securities are the safest place to be in these risk averse times. It’s been an ultra-uncertain geopolitical environment since September 2001 and a highly dangerous financial and economic landscape since since the housing bubble began to deflate in the spring of 2006. Besides, Treasuries won’t look so great if the Congress dithers over raising the debt ceiling and plays chicken with a threat of a Federal Government default hanging in the balance.
- The dollar’s number-one world reserve currency status is unchallenged. And so it has been since the 1950’s, yet the dollar is 75-80% weaker than its old fixed parities against the yen and Swiss franc and down about 65% relative to the DEM-translation value of the German mark. Reserve asset preeminence and a strengthening value against other currencies are two wholly different matters that analysts often mistakenly view as synonymous.
- America is also the only geopolitical superpower left standing. Big holders of offshore dollars like Saudi Arabia, other middle eastern oil exporters, Japan, and China either depend on America’s military assistance or have a big stake in the U.S. economy running well. So it’s in their collective interest that the dollar not implode. That’s been true for decades like the above two factors but didn’t prevent the dollar from losing enormous cumulative ground.
- U.S. policymakers enjoy a degree of freedom in domestic interest rate policy and currency management not shared by their European counterparts. True, and that will allow them to use currency depreciation against their main trading partners rather than price deflation to bolster competitiveness as a counter-weight to the drag of deep fiscal spending cutbacks.
- Quantitative easing is about to end. Federal Reserve Chairman Bernanke denies that such a step means that monetary conditions will tighten. He doesn’t expect a big rise of long-term rates to ensue. Even if it did, the dollar wouldn’t necessarily appreciate. During 1994, the ten-year Treasury yield from as low as 5.54% to as high as 8.02% while Fed policy was being tightened, but it was a period of dollar weakness, not strength, until the spring of 1995 and a palpable shift in U.S. dollar policy.
- Central banks like the ECB, Swiss National Bank and Bank of Japan will be inhibited from tightening their credit stances for fear of promoting even stronger domestic currencies. However, in a year when ECB leadership will be changing and investors are doubting whether the euro can hold together, it may be more important than ever for the ECB to err on the side of orthodox anti-inflationary policy, lest expected inflation slip loose from its anchor.
Currencies do not react in lock-step to changes in central bank interest rates. What counts most is not so much how policy is evolving but whether investors consider policy to be appropriate. Euroland, Britain and Japan are grappling with some very difficult economic problems, to be sure. However, the United States is also caught between a rock and a hard place. There are 1.19 million fewer jobs than there were ten years ago, and the jobless rate is still at a stratospheric 9.0% and all-too-lengthy in its average duration. At the same time, consumer price gains are accelerating. In total, such advanced from a 1.2% annualized rate in the six months to October 2010 to 5.1% in the ensuing six-month period to April of this year. Energy price inflation picked up to 35.0% from 4.2%, and the core index that excludes food as well as energy doubled to a pace of 1.8% from 0.9% in the earlier six months. If Treasury yields rise because of rising expected inflation, the dollar is unlikely to benefit. Impatience will mount if the Fed delays its first rate increase to allow the economy’s slack to lessen. Alternatively, if the Fed gets ahead of investor expectations in shifting its policy stance as it did in the early 1980s, the dollar will not benefit automatically. The Volcker Fed’s tight monetary stance was combined with a loose fiscal posture. This time fiscal policy will be restrictive, and the strong economic growth that developed in 1983-4 is unlikely to be replicated.
I finally wish to point out the ultra stability of the yen. This can be best seen in the sequence of monthly averages. The mean monthly dollar/yen values were 81.83 last October followed by 82.52 in November, 83.25 in December, 82.67 in January, 82.64 in February, 83.74 in March, 83.21 in April and 80.72 in the first half of the current month. This kind of flat-line picture rarely happens in mother nature. One needs guidance. Until March 16-18, the yen had only briefly penetrated 80.0, touching 79.85 briefly in Asian trading on April 19, 1995. Just because Japanese officials have intervened many times this year doesn’t mean they are unprepared to do what it takes to keep the yen from strengthening significantly past the 80 level. Nobody is hoping more than they for the dollar to chart a multi-month course of general appreciation more than they. First-quarter Japanese GDP, due Wednesday, will confirm a contraction that is expected to run about 2.0% annualized in magnitude. By comparison, GDP expanded over 3% in the euro area and by 1.8% in the United States. Japan caught a bad break from the Sendai earthquake. Now the country needs some luck.
Copyright Larry Greenberg 2011. All rights reserved. No secondary distribution without express permission.
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