As we watch emerging market currencies continue their epic collapse against the dollar, it's best not to get caught up in the assumption that the same can't happen to the dollar itself. It can, and as I show here through quantitative monetary analysis, it likely will.
As I detailed back in June, reckless monetary policy is what ultimately did it in for emerging market currencies. They are collapsing pretty much in proportion to how much their supply has been inflated relative to the supply of US dollars. But surprise surprise, the USD supply itself has been inflated about twice as fast as the supply of the top three currencies in the US Dollar Index (UUP) that make up 83% of the weighted index. So, the same thing that's happening to EM currencies now can happen to the dollar relative to those currencies in the Dollar Index, which could eventually bring the index down hard when forex markets catch up to these realities.
What I'd like to do here is break down the Dollar Index into its constituent parts and analyze it from a strictly quantitative monetaristic approach. Meaning, let's compare the money supplies of all currencies that make up the dollar index against the dollar supply over the last 10 years, line that up with how each individual currency has performed against the dollar over the same time period, and see what the Dollar Index should move towards from a strictly money supply standpoint.
I realize that demand for dollars over any other currency in the index definitely affects exchange rates and therefore, the index itself apart from the supply of each currency relative to the dollar. Demand matters and I don't deny that. But with major currencies, supply changes a lot more drastically than demand, so we can assume that while demand for currencies like the yen or pound sterling or euro etc. do fluctuate relative to the USD, the effect that those fluctuations have on exchange rates is muted compared to changes in relative supply, which are much more extreme.
The Dollar Index
The Dollar Index, or USDX, can be broken down as follows and calculated with the following formula:
- Euro - 58.6%
- Japanese yen - 12.6%
- British pound sterling - 11.9%
- Canadian dollar - 9.1%
- Swedish krona - 4.2%
- Swiss franc - 3.6%
USDX = 50.14348112 × EUR/USD -0.586 × USD/JPY 0.126 × GBP/USD -0.119 × USD/CAD 0.091 × USD/SEK 0.042 × USD/CHF 0.036
If we look at monetary inflation for each of these currencies over the last 10 years since September 2008, we get the following.
- Euro - 46%
- Yen - 37.5%
- Pound sterling - 40.7%
- Canadian dollar - 89.4%
- Swedish krona - 89.1%
- Swiss franc - 127%
- US dollar - 84.4%
Some of those numbers may be surprising considering headlines about quantitative easing programs in some of these countries. Remember though that much of QE ends up as excess reserves in banking systems, which does not affect the circulating money supplies for any given currency.
All these numbers are derived from data on Trading Economics.
We also need to take into account the performance of each currency in isolation relative to the USD since September 2008 to determine how in or out of sync each exchange rate is with what would be supply-side equilibrium all else being equal over the last 10 years:
- Euro down 17.7%
- Yen down 4.7%
- Pound sterling down 27.5%
- Canadian dollar down 22.6%
- Swedish krona down 31.8%
- Swiss franc up 13.4%
Taking all this into account, let's start with the euro, the most important component of the dollar index. The USD supply has been inflated nearly twice as fast as the euro supply over the last 10 years, so demand being equal and assuming similar inflation rates going forward for each currency, the euro should climb relative to the dollar. How much? We take the expansion rate of the dollar supply minus the rate of the euro supply and divide by two.
To simplify the numbers, let's assume the US dollar supply was 100 in 2008 and 200 now, and let's assume the euro supply is constant, 200 back then and 200 now. All other things being equal, the exchange rate should fall by 50% in favor of the euro over 10 years or half the difference in the inflation rates ((100 - 0)/2) between the two currencies. So, if the euro was inflated at 46% and the US dollar at 84.4%, it should be up against the US dollar by 19.2% since September 2008 all other things being equal. That's $1.68 per euro.
This is an extreme change and will have extreme global implications. Currency markets need a trigger to set this off though. It won't happen without some kind of crisis, but when the crisis hits, this is the direction that the rate should head in, just as is currently happening in EM currencies. Possibilities for a trigger include a hard Brexit or Italian bankruptcy followed by eurozone price deflation.
Next, yen (JPY). Inflated at 37.5% vs. 84.4% for the USD over 10 years, yet down 4.7% against it. By the same equation, it should be up 23.5% against the USD over the last 10 years, which should put the equilibrium point at around 81.14 JPY per USD.
Will it get that far? Maybe not because September 2008 is an arbitrary date. I chose it because that is around when forex markets became unstable during the financial crisis. But will JPY trend generally in that direction? Most likely, yes. What could trigger it is Japanese deleveraging, and Japan is long overdue for that as it is the most heavily levered developed country in the world relative to GDP.
The British pound sterling (GBP) is down 27.5% against the USD despite being inflated at 40.7% versus 84.4% for the USD. Ceteris paribus, it should be at about $2.17 per pound by the same formula. Yes, Brexit, I know, but we're setting that aside for now.
So far, every currency in the dollar index has been inflated at about half the rate as the USD. The last three, however, have been inflated faster, though they are less consequential and only account for 17% of the Dollar Index by weight.
The Canadian dollar (CAD) has been inflated slightly faster than the USD at 89.4% vs. 84.4% respectively, so it should be down slightly, about 2.5% against the USD over 10 years, which gives it an equilibrium of about C$1.09 per USD. The Swedish krona (SEK) should be at 7.07 per USD. And finally, the most overvalued currency in the dollar index relative to the USD is the Swiss franc (CHF), which should be at around 1.35 per USD, much weaker than it is now. But since the CHF is such a miniscule part of the dollar index, even if it collapses, it shouldn't have much of an effect on the index.
So, where should the dollar index trend towards? Let's plug in the numbers to the formula. It comes out to:
50.14348112 X 1.68-0.586 X 81.140.126 X 2.17-0.119 X 1.090.091 X 7.070.042 X 1.350.036 = 51.43.
A 54% drop in the Dollar Index Ahead?
That's a 54% drop for the dollar index from here, all else being equal. Again, this is not a hard target and demand changes will skew things, but that number should act like a magnet that pulls the dollar index inexorably towards it or somewhere near it unless the supply situation radically changes.
51.43 sounds extremely low, and it is, but it isn't totally outlandish compared to the dollar index all-time low of 71.33 in early 2008.
If this plays out the way I expect, all commodities should go much higher in USD terms over the next decade, with price inflation out of the US close to or in double-digit territory.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in UDN over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.