Take Two: Shouldn’t the Dollar Be Appreciating More Sharply?

March 19, 2014

One year ago, my Insights essay of the week was entitled Shouldn’t the Dollar be Appreciating More Sharply?.  The falling U.S. fiscal and current account deficits were cited.  So were a better composition of capital inflows, stronger growth than found in most other advanced economies, and low inflation.  In the intervening year since the article was penned, the U.S. currency has appreciated over 6.0% against the yen and climbed even further versus some commodity-sensitive monies like the Canadian and Australian dollars.  In each of those cases, however, central banks took action to weaken their exchange rates.  Where the authorities have shown more ambivalence about exchange rate matters, deferring to the judgment of market forces, the dollar has dropped between 5% and 10% against the euro, sterling and Swiss franc.  Since U.S. economic fundamentals have performed in a dollar-supportive way for the most part, it seems right to revisit the question.

The U.S. economic upswing is about to enter its twentieth straight quarter.  Real GDP rose 2.4% over the last four quarters, and the jobless rate is a percentage point lower now than then.  Quantitative easing is being methodically wound down, and officials have not refuted that expecting a first hike of the federal funds rate in the spring of 2015 is as reasonable a guess as any.  The U.S. current account deficit, which averaged 6.0% of GDP in 2006 and 2.5% of GDP in the first quarter of 2013, kept on narrowing to 1.9% of GDP in the final quarter, lowest since the third quarter of 1997.  Back then, the dollar was performing extremely well. 

Several reasons were posited a year ago to explain why the dollar wasn’t stronger.  First, it was noted that since the financial crisis, there was a tendency to do best when investors were sufficiently risk averse to suppress the T.I.N.A. (there is no alternative) mind-set that has been driving equities higher.  Second, Abenomics generates euro demand against the yen, which has a knock-off adverse effect on the dollar’s value against the common European Currency.  Third, secular reserve asset diversification is an omnipresent forces that erodes the dollar.  And fourth, currency markets equate quantitative easing to a stealth weak dollar agenda.

Today’s Commerce Department data on the capital flow financing of the current account support another argument, namely a deterioration between 2012 and 2013 in quality of that foundation of support.  Dollar holders should like to see a manageable U.S. current account deficit but also significant net inflows of long-term direct investment and portfolio investment.  The current account fell to $81.1 billion last quarter from $96.4 billion in the third quarter and $110.4 billion in the final quarter of 2012.  But net direct and portfolio investment swung to a net outflow of $89.1 billion from a net inflow of $111.6 billion in the summer.  The calendar year comparison is even more dramatic.  Whereas the current account deficit fell by $61.1 billion from $440.4 billion in 2012 to $379.3 billion in 2013, net outflows generated by direct investment and portfolio investment transactions leaped $295.2 billion from $13.4 billion in 2012 to $308.6 billion last year. 

The table below focuses on the eight components of direct investment and portfolio investment.  Changes in each component between 2012 and 2013 are noted in the right-most column, where a positively signed change indicates an increased net inflow, a reduced net outflow, or a swing from a net outflow to a net inflow.  The eight elements of long-term capital are U.S. direct investment abroad, foreign direct investment in the United States, U.S. buying of foreign bonds, U.S. purchases of foreign equities, foreign buying of Treasuries, foreign purchases of U.S. corporate bonds, foreign buying of U.S. agency bonds and foreign purchases of U.S. stocks.  The sum of the quarter-to-quarter changes in the “Change” column equals the $295 billion increase in the net portfolio and direct investment outflow from $13.4 billion in 2012 to $308.6 billion in 2013.

Billions of dollars, net 2012 2013 Change
U.S. Direct Investment Abroad 388.3 359.6 28.7
Foreign Direct Investment in the U.S. 166.4 193.4 27.0
U.S. Buying of Foreign Bonds 62.2 162.7 -100.5
U.S. Buying of Foreign Equities 82.6 226.2 -143.6
Foreign Treasury Purchases 156.4 202.2 45.8
Foreign U.S. Corporate Bonds Bought -33.2 177.3 210.5
Foreign U.S. Agency Bonds Bought 56.7 -62.0 -118.7
Foreign Purchases of U.S. Equities 173.3 -71.0 -244.3

The table shows that the direct investment component actually improved by $55.7 billion between the two years, and net foreign purchases of U.S. corporate bonds lent even more substantial support to global dollar demand.  But those items were overwhelmed by a massive shift in two-way equity transactions, heavy U.S. demand last year for foreign bonds and an adverse swing in the directionality of net foreign buying of U.S. agency bonds.

The above data help explain why the dollar didn’t do better in 2013, but this is 2014.  One new element concerns Fed policy under a new leader and several forthcoming changes in Chair Yellen’s supporting cast on the FOMC.  Today’s press conference and released statement stressed policy continuity, certainly in terms of policy goals.  The statement underscores that changes in forward guidance caused by the passage of time and evolution of U.S. recovery “does not indicate any change in the Committee’s policy intentions as set forth in its recent statements.”  Yellen has been a key promoter of the use of forward guidance as a policy tool and seems prepared to be even more outspoken in revealing information than Bernanke.  While her candor and detailed answers were refreshing, I worry that it could backfire especially in currency markets, which are notoriously bad at handling too much verbal communication from officials especially in the face of departures from rigid consistency.  Currency trading became very erratic when former Treasury Secretary O’neill deviated from the mantra that “a strong dollar is in the U.S. interest,” and the euro did not do as well under the first ECB President, whose press conferences were known for loose talk, as it did under his two successors, whose remarks have been more predictable.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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