Dollar Update: Still Weak But Improving

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Includes: FXA, FXB, FXE, FXY, UDN, UUP
by: Calafia Beach Pundit

Measured in inflation-adjusted terms against other currencies, the dollar remains quite weak from a long-term historical perspective, but on the margin it is improving somewhat. This is consistent with monetary policy being "highly accommodative," as the FOMC today noted in its statement, and with a general lack of confidence in the U.S. economy's ability to thrive relative to other economies.

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The chart above shows what is arguably the best measure of the dollar's strength vis-a-vis other currencies. The blue line is the Fed's calculation of the inflation-adjusted level of the dollar against a very large, trade-weighted basket of currencies, and the purple line shows the same measure but against only a basket of major trade-weighted currencies. As should be obvious, the dollar is still very close to its all-time lows by either measure, but it has picked up somewhat in the past year or two.

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The chart above compares the dollar to the euro (blue line) and to my calculation of the purchasing power parity of the dollar/euro exchange rate (the rate which theoretically would make the prices of goods and services in the eurozone roughly equal to those same prices in the U.S.) I note that the euro has been declining somewhat against the dollar for the past several years, with the result that it is less "overvalued" than before. This implies that an American tourist in the eurozone would find that prices are on average about 15% more expensive than in the U.S. At its peak in early 2008 (1.58), I calculate that the euro was overvalued against the dollar by about 38%.

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As the chart above shows, the yen has weakened rather dramatically since last November, and is now only 17% overvalued relative to the dollar. The yen is still strong, but much less strong than it was at the beginning of last year, when I calculate that it was about 50% overvalued. The Bank of Japan has taken aggressive measures to reverse the deflationary pressures that have been a drag on the economy for the past few decades, and that essentially required that the yen weaken from its very strong levels of early last year. The 60% surge in the Japanese stock market since mid-November is a good sign that this shift in policy has been effective, and that the outlook for the Japanese economy is improving.

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If there is anything notable about the chart above, it is the downward slope of the purchasing power parity value of the pound vis-a-vis the dollar that began about four years ago. This is the product of higher inflation in the U.K. than in the U.S., and this deteriorating fundamental is gradually undermining the value of the pound in favor of the dollar. Unless the Bank of England takes steps to tighten monetary policy, I would expect the pound to continue to weaken against the dollar for the foreseeable future. I note that since short-term interest rates are quite similar in the U.K. and the U.S., the pound is trading relatively flat in the forward markets, making a short pound/dollar position relatively inexpensive to establish.

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The Aussie dollar remains one of the strongest currencies in the world. I calculate that American visitors to Down Under are shocked to discover that things cost about 50% more than they do here. The continued strength of the Aussie dollar, combined with the still-elevated level of most commodity prices, suggests that global demand for commodities -- and by inference the health of the global economy -- remains strong.

Note that in all of these charts the dollar remains weak (i.e., undervalued relative to its purchasing power parity). What improvement there has been amounts to the dollar becoming somewhat less weak on the margin. That ties in with my view that what has been driving equity prices in the U.S. higher is not a rising tide of optimism, but a receding tide of pessimism. Conditions here are still miserable (e.g., high unemployment, slow growth, huge regulatory, and tax burdens), but they are better than the market has been expecting.