Strengthening Aura Surrounding the Dollar

May 16, 2013

One hears increasingly the opinion that the dollar may be in a multi-year period of strength.  Optimism rests on several pillars.

One is the broadness of the dollar’s recent advance.  Across-the board appreciation has transpired since this time last Thursday, and important barriers have been pushed aside during the statement week such as 100 yen, 1.3000 per euro, and parity against the Canadian and Australian dollars.  The U.S. currency is up more than 1.0% against the euro, sterling and loonie, more than 2.0% relative to the Swiss franc and yen and more than 3.0% for the week vis-a-vis the New Zealand and Australian currencies.  Conditions for this breakout week had been building, and the dollar is already more than 30% versus the yen above last year’s low and by more than 5% cumulatively relative to the Swiss franc, euro, sterling, and the commodity-sensitive currencies.

Number two, the currency market dynamic may be reverting back to a comparative cyclical framework from the risk on/risk off model that has dominated until recently.  Such a transformation enables the dollar to rise even when equities are in demand.  The U.S. economy has better cyclicals than Europe or Japan.  True, Japanese GDP growth of 3.5% annualized in the first quarter beat the U.S. 2.5% pace by a full percentage point.  But Japanese GDP is a notoriously volatile data series, and the on-year growth rate was just 0.2% in Japan compared to 1.8% in the United States.  Meanwhile, the end of Euroland’s recession remains elusive, and unemployment there keeps setting record highs compared to downward trends in the U.S. and Japanese jobless rates.  The U.S. current account remains in chronic deficit, but has stabilized around 3% of GDP, a level that does not pose immediate danger to the greenback.

Gold’s plunge of 5.6% in the past statement week and 27.7% from its August 2011 high of $1917.90 per ounce is a third reason from optimism toward the dollar.  Global disinflation is one reason for the metal’s eroded value, but gold often moves inversely against the greenback and tends to be well bid when the U.S. currency is considered vulnerable.

Fourth, the dollar seems favored by likely future central bank policies.  Policy risk in Japan is unidirectional.  A substantial reflationary offensive has been launched that is unlikely to be lessened anytime within the coming year and could be augmented if the desired results of positive inflation, quickening real economic growth, and more rapid monetary and lending growth are not sufficiently forthcoming.  It has been acknowledged that this program could lead to an even weaker yen, and Japan’s peers in the fraternity of G7 and G20 leaders have said that such an outcome is okay as long as yen weakness does not appear to be the prime objective.  The ECB is a reluctant policy easier, acting only after considerable delay and doing only enough to survive a succession of euro scares but not forcefully enough to end the recession.  Investors believe that the Fed will begin reducing the size of its quantitative easing sometime in the second half of 2013.

Fifth, the U.S. enjoys better labor market demographics than Japan or Europe, which will become a mounting economic advantage in the longer run, along with the development of indigenous cheap sources of energy.

Finally, a risk exists of bursting asset bubbles, first in bonds and possibly then in stocks.  If that were to happen, currency trading would be again governed by the risk-on/risk-off decision, and risk off would predominate.  The dollar has been resilient in such circumstances before and probably would be so again.

One should not get too comfortable that the dollar is a one-way bet upward.  For now, the U.S. currency is still close to $1.3000 per euro and JPY 100, two psychological points that exert enormous gravitational pull on the currency.  As far as the premise that these might be early days in a multiyear era of dollar appreciation, while that is possible, it’s also true that there are only two real precedents since the dollar floated in 1973, the early 1980s and the latter 1990s.  In both of those cases, U.S. officials were outspoken cheerleaders of the move.  The Reagan Administration believed that the rising dollar gave market validation to the correctness of its economic mix of lower taxes, strong defense, tight monetary policy and widespread deregulation.  Later, a mantra was often quoted by a series of U.S. Treasury secretaries that “a strong dollar in in the best interest of the United States.”  Team Obama is not going to embrace dollar appreciation, however, because the economy needs to stay competitive to rejuvenate manufacturing.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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