Despite all of the negative fundamentals facing the U.S. economy, the unthinkable has happened: the dollar has staged a significant rally. Since bottoming in July the USD has risen 9.6% to over 78 after grinding out a bottom since May. Have the long-term underlying fundamentals changed for the U.S. economy over the recent months? Have the unfunded social security and Medicare liabilities been erased? The answer to both is a resounding NO, but nothing in financial markets move in a linear fashion. The dollar is staging a cyclical rally within the context of a secular bear market, and while many cheer the dollar rally, there are both positive and negative implications that are highlighted below.
Two Steps Backwards, One Step Forward
As mentioned above, the USD is staging a cyclical rally within the context of a secular bear market that has been in place since 2002. An example of a secular bear market with cyclical bull counter-trend moves is the secular bear market in interest rates from 1981 to 2003. Interest rates peaked in 1981 when former Fed Chairman Paul Volcker broke inflation by raising the federal funds rate to double-digit levels. Since that time the U.S. economy witnessed a disinflationary environment where inflation rates moderated over time. However, while the general trend in interest rates and inflation was declining for more than two decades, there were periods of rising inflation and interest rates. The bull market counter trend moves (green arrows) were smaller in magnitude and duration than the cyclical bear market declines (red arrows) as shown below.
Figure 1
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Source: U.S. Board of Governors of the Federal Reserve System
This same pattern has been in place in the USD index that peaked in 2002. Along the way down the USD has staged sharp countertrend rallies with the biggest rally seen in 2005. However, these countertrend bullish moves have been shorter in duration and magnitude than the bear market declines, a textbook definition of a secular bear market.
Figure 2
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Source: StockCharts.com
The biggest moves in the USD Index have been the bullish bounce seen in 2005 and the long bear decline in 2006 to early 2008. Both the bullish bounce and recent bear decline had fundamental developments that supported those moves and current global developments shed light on the recent USD bounce. What has caught the USD bears off guard is that they are looking at the USD in absolute terms rather than in relative terms, which is what exchanges rates are, the relative value between one currency and another. As such, looking at the U.S. economy in isolation rather in a global context will catch dollar bears off guard, which is exactly what has happened over the last few months.
The value of a country’s currency is determined by several economic fundamentals such as interest rates, inflation rates, and overall economic activities. Collectively these factors affect a country's capital and trade flows and thus the supply and demand for a country’s currency. The same goes for other countries, and so the economic fundamentals between two countries influence the exchange rate between them. This helps explain the strong move in the dollar in 2005 and the strong decline over the past two years. Central banks respond to economic activity by managing interest rates where they lower interest rates to stimulate growth and raise rates to slow overheated economies and curb inflation.
In 2005 the Federal Reserve was raising interest rates while the UK was on hold as was the European Union (EU). The fact that our central bank was raising interest rates while the UK and EU were on hold reflects that our economy was more or less relatively stronger. So the demand for our currency relative to the British pound and Euro was also stronger, with a 13.9% rise in the USD Index seen in 2005. Likewise, our economy leads the world economy down with our central bank going on pause in 2006 and lowering rates in 2007 while the EU, UK, and other global central banks were raising interest rates. Our economic activity was slowing while the global economy was expanding, which lead to the whole decoupling theory. The weak US economy relative to the global economy led to a decline in demand for dollars, particularly with a contracting trade deficit, and thus a decline in the USD Index of 22.2% seen from 2006 to 2008.
Movements in the USD Index generally reflect the difference in economic fundamentals between the US and the countries that make up the USD Index. It should come as no surprise then that the USD is rallying currently as the economic activity of foreign countries is now recoupling with the US economy, dispelling the whole notion of the global economy decoupling with the US. Economist Paul Kasriel highlights this point in his recent US economic outlook with an excerpt below.
When the U.S. “Catches a Cold”, So Does the Rest of the World
In the past 18 months, the CNBC/WSJ op-ed happy-talking heads have consistently been wrong. Remember the “containment” argument. No, we are not talking about George Kennan’s Cold War strategy, although it might be getting dusted off given recent events in the Caucasuses. No, we are referring to the notion that problems in the sub-prime sector of the mortgage market would cause little or no harm to the financial system or the real economy as a whole. Another popular Pollyanna principle was a variation on the containment (or Las Vegas) hypothesis – namely, what happens in the U.S. economy stays in the U.S. economy, otherwise known as decoupling.
We have warned ad nauseam about the perils of buying into the containment myth. Now, we want to scribble a bit about the decoupling myth. We never understood how there could be as much economic globalization but that a recession in the largest economy would leave the rest-of-the-world’s economies relatively unscathed. Consider that U.S. nominal imports of goods and services were 6.6% of the rest of the world’s nominal GDP in 2006, up from 4.5% 10 years earlier in 1996 (see Chart 1). Now that U.S. imports are contracting in real terms, both year over year and quarter to quarter (see Chart 2), wouldn’t you think that this would be having a negative impact on economic growth in the rest of the world?
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Source: Northern TrustPaul Kasriel, Northern Trust
August US Economic Outlook
Economic activity has decelerated sharply in the six countries that make up the currency weights in the USD Index and help explain the recent USD rally, with the economic activities of the four countries that make up the largest currency weights in the USD Index listed below in order of their currency weight, collectively making up 92.2% of the USD Index.
Figure 3. Euro Zone (57.6% of USD Index)
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Source: DismalScientist
Figure 4. Japan (13.6% of USD Index)
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Source: DismalScientist
Figure 5. UK (11.9% of USD Index)
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Source: DismalScientist
Figure 6. Canada (9.1% of USD Index)
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Source: DismalScientist
To graphically illustrate the point above I took the central bank interest rate spread between the US Federal Reserve and the central banks of the six countries in the USD Index, weighted by their composition in the index. The spread was graphed along with the year-over-year (YOY) rate of change in the USD Index. As seen below, the dollar’s YOY rate of change generally tracks the weighted central bank rate spread and rebounded sharply in 2004 and into 2005 as the central bank spread rose, while peaking in 2006 as currency traders discounted greater economic weakness in the US relative to its trading partners. The strong rebound recently likely reflects an unwinding of large dollar short positions as well as currency trader’s expectations that the EU is likely to begin lowering interest rates in the near future as the ECB begins to focus on economic weakness rather than inflation. The rate of change in the dollar index bottomed in 2003, more than a year ahead of the first Federal Reserve rate hike, and the recent rate of change bottom is likely discounting a higher central bank spread next year as the ECB and other central banks lower interest rates.
Figure 7
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Source: Bloomberg
Many have lamented this year the Dollar’s decline and called for stability in the dollar, which is what we are seeing as of late. There are both positive and negative implications of the dollar’s recent strength, which are highlighted below.
Good Cop
Perhaps the greatest effect of a rising dollar is a likely moderation in inflation (price inflation). Concurrent with the bottom in the USD was a top in commodities, with oil down more than 25% and gold down roughly 20%. A rising dollar and falling commodities will help bring down headline inflation over the rest of the year, with perhaps a sharp decline to be seen in the months ahead as the YOY comparison for headline inflation will make a high inflation rate unlikely.
Figure 8
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Source: BLS/ Federal Reserve Bank of Atlanta
One of the contributing factors that will bring down headline inflation is falling import inflation. As the USD rallies, the prices of imported goods will come down, with a peak in import inflation likely to be seen with the recent dollar rally. The dollar’s movements typically lead import price inflation by seven months (USD shown displayed below inverted on the right axis).
Figure 9
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Source: BLS/Federal Reserve Bank of Atlanta
Another positive development on the inflation front is that China has slowed the appreciation of the Yuan. China allowed the Yuan to appreciate to help combat rising inflationary pressures in their country in 2006 and 2007. A stronger Yuan relative to the USD made imported Chinese goods more expensive and China became a source of price inflation rather than deflation in 2007, partly explaining the recent spike in inflation over the past year, with energy prices obviously another major component.
Figure 10
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Source: BLS/ U.S. Board of Governors of the Federal Reserve System
China has recently shifted its focus from inflation to growth as it appears inflation has peaked in the country. While the Yuan is still appreciating at a double-digit YOY rate, the three months the annualized rate of change has shown a dramatic deceleration and resembles the movements in the YOY inflation rate as shown below. Falling inflation in China will allow the country to continue to slow the appreciation of the Yuan which will help bring down US import inflation going forward.
Figure 11
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Source: DismalScientist
Figure 12
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Source: U.S. Board of Governors of the Federal Reserve System
While headline inflation is likely to slow, we may have a change in trend where we have headline inflation falling while core inflation is rising. It appears the inflationary pressures that were in the pipeline over the last year are likely to creep into core inflation as businesses finally bend from rising input costs as they try to protect their margins. The small business survey done by the National Federation of Independent Business (NFIB) shows the highest percentage of firms raising prices in the index’s history, hitting a high of 24.4% last month, beating the previous all-time high of 22% in 1989. This is significant as the net percent of small businesses raising prices leads core CPI by roughly 14 months, meaning past inflation pressures may begin to spill into the broad economy over the coming months.
Figure 13
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Source: BLS/ NFIB
Corroborating the NFIB developments is the ISM non-manufacturing price index, which hit an all-time high of 80.77 last month. While the NFIB data points to an acceleration in core CPI currently the ISM data point to first a deceleration heading into year-end followed by renewed inflation seen in the remainder of 2009, which the Federal Reserve may have to address with an interest rate hike.
Figure 14
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Source: BLS/Institute for Supply Management
Bad Cop
While headline inflation is set to moderate, the strength in the dollar is not entirely positive. What many pundits have grabbed hold of lately is the argument that rising exports will help keep our economy out of a recession. Exports have indeed risen dramatically on a YOY basis as the trade-weighted dollar has fallen. The link between exports and a falling dollar (inverted below) is shown below.
Figure 15
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Source: BOC/Federal Reserve Bank of Atlanta
A rising dollar will make our goods more expensive and curb the growth seen in exports, with exports being a major support to quarterly GDP figures over the past year. Fourth quarter GDP came in at -0.17% last year while backing out the contribution of exports would have shown a -0.82% rate and led to a 0.27% annualized growth rate in the first quarter of this year rather than the 0.874% rate seen.
Figure 16
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Source: BEA
The stimulus checks were a significant boost to second quarter GDP and will be a one-off contribution as consumption trends continue to point downward and will weigh on overall GDP growth as consumption still remains the largest component of GDP. If export growth slows going forward as a result of a stronger dollar and weakening global economy one of the last supports to economic growth may fall by the wayside. This is why my outlook for our economy next year is dismal.
Figure 17
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Source: BEA
Another negative consequence of a stronger dollar will be weaker corporate profits from companies that derive a major portion of their revenue from overseas. For example, McDonald’s derives 65% of its revenue from overseas and will feel the pain of a rising greenback, as will many other U.S. corporations. Falling corporate profits derived from overseas will also remove the last support to domestic corporate earnings as domestic industry profits turned negative last year. Second quarter profits for domestic industries fell by 20.6% YOY while corporate profits from overseas rose 26.4% YOY. While foreign profits are still high, they have come down from the peak YOY rate of 45.6% seen in the fourth quarter of last year and are following the trend in domestic-based industries, debunking the decoupling myth which has been nothing but the usual; global economies LAG the US, not decouple.
Figure 18
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Source: BEA
While all the talking heads on CNBC may be jumping up and down in excitement about a rising dollar, they should be careful what they wish. While headline inflation is set to decelerate going forward, the picture in 2009 may see the spillover effects of headline inflation pouring into core inflation. A stronger dollar may come back to bite all the dollar bulls by removing the last pillars of support for our economy and corporate profits. The US dollar has been in a secular bear market since 2002 and we are currently seeing a cyclical bull market counter trend bounce as the rest of the global economies recouple with the US, which is likely being discounted in the currency markets currently. As foreign central banks bring down their interest rates they will near the end point of their easing as our central bank did earlier this year. The point when foreign central banks end their easing programs and our Federal Reserve may even raise interest rates to combat inflation will likely be discounted in advance in the currency markets, and mark the next leg down in the secular dollar bear market.
