Dollar Uptrend Back on Track

February 15, 2017

The dollar is back in the saddle. After a strong performance last autumn, the dollar hit a speed bump in January but experienced solid demand in the first half of this month. Against both the euro and yen, the U.S. currency posted gains in each month of last quarter. So far in February, it has recovered roughly three-fourths and one third of its January losses against the euro and yen, respectively, and it has risen a bit over 1% against sterling, which had risen in both November and January and in the three months ending January on balance.

The dollar is strengthening on U.S. economic trends and in spite of daily political drama in Washington in these early days of a new administration. Greater expenditure on U.S. infrastructure and the biggest corporate tax reforms since the 1920s are promised, and the Federal Reserve appears determined to quicken the withdrawal pace of its monetary stimulus.

Looser fiscal policy does not always insure a rising dollar. The last period of fiscal reflation during the second Bush presidency, which covered eight years, saw the dollar fall 4.0% per annum against the euro. Under Reagan’s similarly long period in power, it depreciated on balance by 1.0% a year versus the Deutsche mark, more than reversing a stellar performance in his first four years.

Likewise, the dollar doesn’t always rise when the Federal Reserve is raising interest rates. The last normalization of the federal funds rate, a rise from 1.0% in mid-2004 to 5.25% in mid-2006, saw the dollar decline by 4.7% against the euro but rise 5.2% against the yen. The dollar also fell extensively against the mark and yen during the doubling of the federal funds rate to 6% in a year’s span between early 1994 and early 1995.

Needless to say, the coming U.S. economic policy changes have received a lot of applause from Wall Street investors and analysts. Moreover, the implications for stocks and Treasury yields, both of which have risen impressively, depict an environment that is believed to be supportive for the dollar in the short term. Image is important.

Washington political melodrama for markets has been an entertaining side show that isn’t driving decisions on money. In the short run, this isn’t all that unusual. Currency market history is full  of instances when big political turmoil came and went without exerting lasting effect on the market. Moreover, for every worry about America’s internal political wars, one can find worse developments abroad. The French, Dutch and German elections pose huge challenges for the common currency experiment, and the health of banks in that region remains highly suspect. In an all-out tit-for-tat trade war, the U.S. in the short run is likely to suffer less severely than other economies.

Major economic disasters often have a long fuse, taking many years to fester before evolving into clear and present dangers. The U.S. economy expanded almost 5% per annum in the seven years through 1929. The seeds of the inflation problem that landed during Carter’s watch were sown over the prior decade by Lyndon Johnson’s guns-and-butter pursuit of unwinnable war against Vietnam plus Great Society programs at home and then nurtured by permissive monetary policy during the eight year Fed Chairmanship of Arthur Burns. While Calvin Coolidge managed to get out of D.C. a half year before the Wall Street crash in 1929, George W. Bush was not so fortunate. Imbalances caused by financial market deregulation and big fiscal deficits hit the economy in his final year, leaving a very different legacy than he had sought.

The dollar’s performance will strongly influence how the economy performs in the next few years. America felt the depression much more severely than Britain in large part because the U.S. embraced the gold standard rules longer than did the U.K., which devalued the pound in 1931. U.S. inflation in the 1970s was not effectively addressed until officials understood that reestablishing domestic price stability would not be possible so long as the dollar kept losing external value.

The wild card in a forecast of dollar appreciation over the coming year is uncertainty over U.S. tolerance for a rising dollar. Trade lies near the center of President Trump’s views on economic health. Verbal complaints were made during the election campaign and since about unfair currency manipulation. It doesn’t matter that such allegations misunderstand the cause and significance of trade and current account imbalances. All that’s important is that the bully pulpit may be used to counteract perceived currency market threats.

When a currency has been chronically weak and appears undervalued according to measurable benchmarks like purchasing power parity, those conditions are not sufficient to turn the currency upward. Other policies have to change, and investors have to regain confidence that policymakers have the will and means to do whatever it takes to stop the currency from weakening. The U.S. currency danger of the dollar becoming too strong is different altogether and much easier for policymakers to rectify. There is no excuse for having a currency significantly stronger than wanted so long as a government is willing to subordinate all other economic goals to achieving depreciation.

Copyright 2017, Larry Greenberg. All rights reserved. No secondary distribution without express permission.

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