U.S. Dollar Strength Suggests Continuing Decline in Canadian, Australian & U.K. Currencies – and Price of Gold – Here’s Why (+6K Views)

It’s been an impressive rally of late, but as the chart below shows, from a long-term perspective the dollar is still relatively weak, whether measured against a trade-weighted, inflation-adjusted basket of major currencies or against a similar basket of more than 100 currencies.

• Relative to its all-time high of May, 1985, when the economy was booming and the Fed was fighting inflation with sky-high interest rates, the dollar today is almost 30% weaker.
• Relative to the early 2000s, when the economy and equity markets were booming and the Fed was fighting the specter of rising inflation, the dollar today is about 20% weaker.

[A stronger U.S. dollar is likely to be both an economic and market positive as the chart below illustrates.

RBC Capital Markets]

U.S. Dollar’s Strength & Weakness Relative to 5 Major Currencies

Purchasing Power Parity (PPP) theory holds that, over time, currencies move vis-a-vis others in a way that reflects changes in relative prices between between countries. Currencies that depreciate against others typically have higher inflation rates, and currencies that appreciate have lower inflation.

For each currency I’ve picked a base year in which I thought that prices were in rough equilibrium, then adjusted that value over time for changes in relative inflation rates. The current PPP value of each currency is therefore approximately equal to the exchange rate that would produce roughly equal prices for a given basket of goods and services in each country.

By my calculations, the current PPP value of the Euro vis-a-vis the dollar is about 1.16 dollars per Euro. Since the Euro is currently trading at 1.29, that implies that a U.S. tourist visiting the Eurozone today would find that goods and services there cost about 10% more than in the U.S. on average (1.29/1.16 = 1.11).

As for Sterling, my calculations suggest that goods and services in the U.K. today cost about 25% more than they do in the U.S. In other words, the pound is about 25% “overvalued” relative to the dollar. The fact that the green line has been sloping down for the past several years tells us that U.K. inflation has been higher than U.S. inflation, and that over time the pound is therefore likely to fall relative to the dollar, all other things being equal.

The yen has experienced a rather dramatic weakening over the past three years, falling from a high of 75 to almost 109, for a loss of over 30% against the dollar. Big currency losses like this are rarely good news, but in this case the big drop in the yen has coincided with huge gains in the Japanese equity market, as the second of the charts below shows. I think that’s because the yen had been so strong for so long against almost every currency on the planet that it had created deflationary pressures which were suffocating the economy.

The yen’s relentless appreciation over the previous 40 years made life very difficult for Japanese industry, for example, since they had to continually cut their costs to remain competitive with overseas manufactures. Now that the yen is closing in on its PPP value relative to the dollar, and the Abe administration is pursuing more growth-oriented fiscal policies, it’s become very good news for the Japanese economy and for the world.

As the first of the two charts below shows, big changes in the Australian dollar’s value tend to go hand in hand with big (and inverse) changes in the prices of commodities. Commodities peaked in 2011 about the same time the Aussie dollar hit its all-time low; a rising dollar since then has coincided with a return of weaker commodity prices.

Since the Australian economy is heavily dependent on commodity exports, the Aussie dollar has tended to move with commodity prices. It too peaked against the dollar in 2011, and since then it has dropped almost 20% relative to the U.S. dollar. By my calculations, the Aussie dollar is still about 40% “overvalued” against the U.S. dollar, making Australia a rather expensive vacation destination for U.S. tourists (and, by the same logic, the U.S. offers very inexpensive vacations for Australian tourists.)

Why was the U.S. dollar so weak three years ago? The list of possible causes is long, but I think the important ones are:

1. fears that the Fed’s QE efforts would debase the dollar and lead to higher inflation;
2. fears that trillion-dollar federal budget deficits would prove to be the norm and that in turn would lead to a significant rise in U.S. tax burdens;
3. fears that an onerous increase in regulatory burdens under Obamacare and Dodd-Frank would weigh on the economy; and
4. fears that the U.S. economy was vulnerable to a double-dip recession.

We’ve still got lots of problems to deal with (and the dollar is still weak), but we now know that:

• the Fed hasn’t (yet) made a big inflation mistake, and is on the verge of ending QE and beginning to normalize short-term interest rates,
• the federal budget deficit has fallen by two-thirds and is currently quite manageable,
• the debate over entitlement spending, which holds the key to the long-run budget outlook, is now centered around when and by how much spending can be cut, not whether. The ongoing failure of Obamacare and the long list of bureaucratic scandals in recent years have convinced a majority of the people that we suffer from too much, not too little government. Too much government killed Greece, and it’s killing Venezuela and Argentina as we speak and, finally,
• the U.S. economy has managed to grow by a relatively steady 2% pace for the past five years, and has been able to grow despite pronounced weakness in the Eurozone and a significant slowdown in the Chinese economy.

In short, things have turned out much better than the market feared. Looking ahead, it’s now pretty clear that:

• the Fed is going to pursue tighter monetary policy than the ECB, the BoE, and the BoJ,
• interest rate differentials are moving in favor of the U.S. dollar (i.e., U.S. short-term rates are rising relative to overseas rates) in anticipation of this, 
• and that has also helped boost the U.S. dollar, as the chart below shows.

Even though the U.S. economy is saddled with:

• a very uncompetitive tax system,
• a hugely burdensome regulatory environment, and
• an abysmally low labor force participation rate,

it’s doing better than most other countries. In short, things haven’t turned out nearly as bad as the market feared.

Investment implications

1. U.S. investments look attractive relative to non-dollar investments.
2. Commodity prices are likely to weaken further if the U.S. dollar continues to strengthen.

This is unlikely to be bad news for emerging market economies, however, because:

• the dollar will be strengthening, and
• interest rates will be rising, as the outlook for the U.S. economy improves. (A stronger dollar that results from overt and aggressive Fed tightening can be very bad news for emerging markets, since it presages a sharp slowdown in the U.S. economy—that was the case in the early 2000s. Every recession in the past 50 years has followed a period of very tight monetary policy, as evidenced by high real interest rates and a flat or inverted yield curve. We’re years away from that.)

Summary

As the PPP charts above suggest, the currencies with the most to lose potentially against the U.S. dollar are the Australian dollar (40%), the Canadian dollar (20%), and British Pound Sterling (25%).

A stronger dollar would most likely lead to weaker commodity prices, especially so in the case of gold. As the chart below suggests, gold prices “overshot” commodity prices in the wild and wooly days following the near-collapse of global financial markets during the depths of the Great Recession, and the onset of the Fed’s unprecedented expansion of its balance sheet.

Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.

*http://scottgrannis.blogspot.ca/2014/09/the-return-of-king-dollar.html (I’m pleased to note that in my predictions for 2014 I correctly thought that the dollar would strengthen this year, and that gold and commodities were unattractive investments. Check out my other predictions, most of which still appear to be correct.)

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