Growing Dollar Confidence

September 9, 2011

Simply put, the dollar is performing better.  It posted solid gains against commodity-sensitive currencies in August, climbing 3.0% against the kiwi, 2.8% versus the Australian dollar, and 2.2% relative to the Canadian dollar.  As of 15:10 GMT today, those advances had been so far extended in September by another 3.7%, 2.1%, and 1.7%, respectively.  The dollar’s biggest jump this month has been a 9.6% appreciation against the Swissie, and that move followed by  a 2.5% gain in August.  The greenback has even been well bid lately against currencies that were resilient last month.  The U.S. money has risen 4.8% so far in September against the euro, which had dipped just 0.1% in August, and it is 1.4% stronger versus the yen, which had risen 0.5% in the prior month.  The rate of appreciation against sterling has built up more steam, with a 2.2% rise this month after a 1.0% gain in all of August.  Relative to the yuan, the dollar dropped 0.9% last month but firmed 0.2% in the first third of September.

This good post-Labor Day holiday performance is atypical because the autumn trading season tends to be characterized by dollar softness.  Note that in currency trading, the autumn encompasses all time in the calendar year following Labor Day.  Last year, the dollar fell between Labor Day and yearend by 4.0% against the euro and 2.9% versus the yen.  Over the 35 years from 1976 through and including 2010, the dollar recorded an average decline in this season of 2.5% against the German mark and/or euro.  In a subset of that period (1976-1991), the dollar only rose in three autumn seasons and posted an average deprecation of 5.0%.  For just the most recent ten years of data, the dollar registered an average drop of 2.6% each autumn against the euro and 2.7% relative to the yen.  Over the last 31 autumn seasons, the mean decline against Japan’s currency was also 2.7%.  This historical backdrop makes the dollar’s recent buoyancy even more impressive than generally realized.

The dollar caught a huge break from the desperate decision by Swiss National Bank officials to sell local currency, however forcefully the task requires to impose a ceiling peg on the Swissie’s euro cross relationship.  This pledged action is unconditional, unlike the Fed’s long-standing forecast of exceptionally low short-term interest rates, which carries the stipulations that resource utilization be low and U.S. inflation prospects stay subdued.  If a central bank is willing to subordinate all other priorities as Swiss authorities are doing, there is no excuse for having a currency that is stronger than desired.  Unlimited sales of the local currency and the collateral damage of accelerating inflation will secure the exchange rate target quite quickly.  Policymakers at the Bank of Japan, in contrast to those at the SNB, have always been unwilling to make those concessions, and as a consequence, Japan has suffered through two decades with real growth averaging less than 1% per annum, plus domestic price deflation, anemic money and credit growth, and a 77.5% cumulative decline in share prices.  The holy grail of medium-term price stability is not as virtuous as it is cracked up to be.

A pegged Swiss franc will hurt the euro and support the dollar in the near term.  Swiss monetary officials are implementing their policy by selling the euro, which is the main dollar alternative for reserve asset portfolios.  The Swissie itself is no longer an attractive store of value because of negative Swiss interest rates and the lack of potential capital gains from franc appreciation.  Much of that currency’s appeal had arisen from Switzerland’s independence from the tainted politics in other countries.  Now the franc is tied to a currency that could break apart literally.  Another dollar alternative, gold, could also be hurt by the SNB’s new policy.  This isn’t the first time the Swiss have subordinated domestic monetary policy to an exchange rate target.  While market players are most familiar with the unsuccessful effort in 2010, the 1980’s saw an extensive period of imposed franc/mark stability, and that interval occurred at a time of gold/dollar stability.  The francs per D-mark relationship averaged 0.8354 in 1982, 0.8227 in 1983, 0.8255 in 1984, 0.8336 in 1985, 0.8281 in 1986 and 0.8296 in 1987, and after having peaked at $850 per ounce on January 21, 1980, gold rose just 1.3% per annum from $384.16 in January 1982 to $419.25 in December 1987. 

The dollar remains low historically, leaving ample scope for near-term gains if other factors remain supportive.  It is marginally less than 3% stronger than its 2011 mean against the euro and over 13% below last year’s peak against the common European currency.  The dollar’s current distance from the yen’s all-time high set last month is only 2.3%, and the dollar would need to climb about 4% just to return to its 2011 yen mean.  Even after a double-digit percentage loss since peaking on August 9, the Swiss franc has merely returned to less than 1% below its year-to-date average dollar level. 

The European Central Bank is shifting its bias in response to a much greater regional growth slowdown than had been foreseen, which is providing one more accelerant to the euro debt crisis.  Greece’s bond yield premium vis-a-vis bunds is some 300 basis points wider than in late August.  The Italian, Spanish and Portuguese spreads have widened to over 300 bps in the first two instances and almost 1000 bps in the third case.  A dark cloud of suspicion hangs over European banks, and market chatter is full of comparisons in how similar things feel to the period right before the engineered collapse of Lehman Brothers.

Whereas an ECB rate cut is considered possible as soon as November or December, the Fed appears to have less maneuvering room.  The Fed funds rate remains anchored, and previous experience with quantitative easing remains an object of considerable criticism just months before the first presidential primaries.  Japan is not out of the woods, and officials there continue to gripe about the yen’s strength, whose strength in inflation-adjusted terms is not nearly as extreme as the Swissie had become.  That said, the yen seemingly has much greater scope for retreating toward 80 per dollar than strengthening toward new highs beyond 75/USD over the coming six months.

Investors should be careful about inferring that the dollar’s better near-term outlook might be the start of a multiyear uptrend.  Many are making that leap of faith.  With two well-explained exceptions, cycles of dollar appreciation in the 40 years of floating rates have lasted less than twelve months.  The bull run of 1980-early 1985 was associated with a popular government, peace, tight money, very loose fiscal policy, and a return to price stability from double-digit inflation.  None of those conditions will hold remotely in the coming 1-3 years.  The late 1990s were a period of further inflation deceleration, unchallenged U.S. geopolitical hegemony and peace, a large federal surplus, and strong growth in GDP and productivity.  Globalization and deregulation were viewed in a positive light then, unlike now, as indications of a continuing solid U.S. economic performance, and animal spirits unleashed by that euphoria gave vent to a  proliferation of asset bubbles. 

The United States lacks genuine and absolute positives to sustain a long-term and substantial cumulative dollar gains of those two earlier times.  The balance of payments is in chronic deficit at a time of debt deleveraging.  Interest rates will remain very low and are as likely to trend even lower from here as turn upward.  Short of a big, widely supported war to unite Americans, the divisive politics aren’t going to be repaired in the next fourteen months or, for that matter, during the next presidential cycle.  Having better productivity and demographics than Japan or Europe will not provide sufficient support to offset the dollar’s long-term disabilities.  If the currency weren’t the preeminent reserve currency, maybe it would be good enough for the U.S. to enjoy certain structural advantages in a struggling global environment.  But huge stocks of offshore dollar holdings will instead make diversification too tempting and too irrepressible.

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

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