Grab The Reins on The Dollar

By: Michael Ashton | Mon, Jun 1, 2015
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Let us all grab the reins on the dollar. Yes, it is true: the buck is up some 25% from a year ago, and at the highest level in more than a decade. After retracing recently, the dollar index has been chugging higher again although it has yet to penetrate recent highs. But put this all into context. In the early 1980s, the dollar index exceeded 160 before dropping nearly by half. A subsequent rally into the early 2000s was a 50% rally from the lows and took the index to 120. This latest rally is a clear third place, but also a distant third place (see chart, source Bloomberg).

US Dollar 1975-2015

We can probably draw some instruction from reviewing these past circumstances. The rally of the early 1980s was launched by the aggressively hawkish monetary policy of Paul Volcker, who vowed to rein in inflation by restraining money growth. He succeeded, and took core inflation from nearly 14% in 1980 (with the dollar index at 85) down to 4.5% in 1985 (with the dollar index at 160). If you make a thing, in this case dollars, more scarce, its price rises. An optimistic press wrote about the "Superdollar" and the return of that signature American optimism.

Well, one out of two isn't bad. The dollar soon slipped back, as other central banks instituted similar monetary restraint and the relative advantage to the greenback faded. It bounced around until the late 1990s, when Congress attacked the federal deficit - actually turning it into a surplus in the late 1990s. The dollar rallied fairly steadily from 1995 until topping out between late 2000 and early 2002, thanks to aggressive easing action from the Fed which took the Fed Funds target rate from 6.5% to 1.0%.

But it is important to remember that with currencies, it is all relative. If everyone is easing or everyone is tightening, then there shouldn't be much in the way of relative currency movements. Thus, even though the Fed has spent most of the last seven years doing quantitative easing, the dollar hasn't done much on net because everyone else is doing so as well. All currencies should be cheapening relative to real assets (and are, with respect to real estate, but not so much with commodities...for reasons that make little sense to me), but not relative to one another.

But recently, the dollar has outperformed because the investing community collectively perceived a divergence in monetary policies in the offing. While Japan and Europe have been ramping their QE higher, the Fed has ended its QE and at least some people expect them to raise rates soon. If it were to actually happen that money growth in Japan and Europe continued to accelerate while it slowed in the U.S., then it makes perfect sense that the dollar should appreciate. That is happening a little: the chart below (source: Bloomberg) shows that in the most recent data, European M2 money growth exceeded US M2 money growth (as well as UK and Japan M2 money growth) for the first time since 2008. Look at that spike on the red line in the chart below!

M@ for US, EU, UK and Japan

On the other hand, there doesn't seem to be anything dramatic happening on that chart, with all growth rates between 3.5% and 6.1%. And, honestly, I think investors have it generally wrong in thinking that if the Fed hikes US interest rates, money growth should slow and overall monetary conditions should tighten. Quite the contrary: I believe that with enormous excess reserves in place, rising interest rates will only spur bank interest in lending, and money growth will not slow but may even increase. But in any event, dollars are not about to become more scarce. The Fed doesn't need to do any more QE; the vast quantities of excess reserves act as a reservoir of future money.

I have been surprised by the dollar's rally, but unless something changes in a more serious way I don't expect the rally to end up resembling the two prior periods of extended dollar strength.

 


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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
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Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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