“When you’re on a business trip that gets extended and you don’t have any more clean shirts, you wear the one that’s least dirty.” – Mohamed El-Arian
It has been over five years since Bernanke and company responded in full force to the deflationary threats brought on by the global financial crisis. Interest rates were cut rapidly to the zero bound, and multiple rounds of quantitative easing ensued. The central bank has since purchased roughly $3.5 TRILLION worth of securities out of the open market, leaving the previous holders of those securities with electronically-minted cash. (See Fed Ed: Mood Management for a detailed discussion of quantitative easing and its true impact on the financial system and economy.) This rapid expansion of the monetary base has elicited innumerable predictions of runaway inflation and a crashing US Dollar. On the surface these calls seem to make common sense. If inflation is defined as too much money chasing too few goods, then the Fed’s “liquification” of the financial system over the past five years virtually has to create inflation and weaken the currency – at least this is how the line of thinking goes.
While these predictions might be shown to have some teeth over the long run, the reality thus far has been relatively tame inflation and a strengthening US Dollar. Consider the chart below showing the performance of the US Dollar relative to other world currencies. The Dollar Index is significantly higher than where it was three years ago, showing particularly strength in recent months.
There are myriad reasons for the recent strength in our currency, but one of the simplest explanations is that despite its problems the US Dollar is still the “cleanest dirty shirt in the closet”. The fact of the matter is that the headwinds of over-indebtedness, soft labor trends and anemic private sector growth are not at all unique to the United States. Consider the fact that outside of the Dollar the two largest trade-weighted currencies in the world are the Euro and the Yen.
The Eurozone is dealing with many of the same economic challenges as the US, but is in a far more complicated mess. The monetary union is structured in such a way that the member countries are linked in monetary policy, but are distinct and separate in fiscal policy. This leads to dysfunction and tension as the central bank tries to unite its member countries in common monetary objectives while watching them scatter in different directions on issues of government spending and borrowing. Even as the US economy limps out of its post-financial crisis slump, the Eurozone appears to be on the verge of double-dipping into yet another recession while bank leverage, government debt, and unemployment rates all look relatively weaker than the levels here in the US. Add to the mix the fact that the European Central Bank is going in the opposite direction as its US counterpart, and it’s not hard to see why the US Dollar might come out looking relatively attractive in comparison to the Euro.
And let’s not forget the Japanese Yen, third most important to global trade behind the Dollar and the Euro. Japan has been mired in a debt-induced economic coma for over two decades now. Government liabilities relative to GDP are far larger than any other developed country, interest rates along the entire curve are the lowest in the world and the Bank of Japan’s money printing efforts make the Fed’s look like child’s play. Add to all this the fact that Japan’s economy contracted in the second quarter at the fastest pace since 2009 (-7.1% annualized), and once again the US Dollar comes out looking pretty good.
One of the side effects of a strong currency is that it puts downward pressure on inflation via lower import prices. Everything we purchase from countries around the world – cars, electronics, oil, etc – cost the American consumer fewer of their US Dollars.
A strengthening currency also makes our assets more attractive to foreign investors. Capital moves across global borders into US real estate, stocks and bonds in search of strong total, currency-adjusted returns. This can have positive knock-on effects for the economy as personal, corporate and government balance sheets are improved and confidence rises.
Although having a “strong dollar” feels like an all-around patriotic objective, there is another side to this coin as well. In the same way that our imports become cheaper, our goods and services become more expensive to foreign consumers. This is a headwind to our exports and can be particularly negative for sectors of our economy that are trying to be price competitive on a global scale. Additionally, many American corporations generate significant amounts of their revenue through operations abroad. A strengthening US Dollar devalues those foreign revenues and makes it more expensive to bring those profits home by converting them back into US Dollars. Thus, a strong dollar policy should be viewed in light of both the benefits and the drawbacks that come with a globally firm currency.
As a nation we still face a lot of challenges as we continue repairing the damage caused by the financial crisis. That said, we have made a lot of progress and we’re continuing to see small victories on the margin as we move slowly in the right direction. As we recently discussed in The Long Hike, this has created a backdrop against which Janet Yellen’s next major policy move will likely be to raise short-term interest rates. This fact alone puts the US in a league of its own amongst developed economies around the globe, and until something changes it means the US currency will continue to be viewed as the cleanest dirty shirt in the closet.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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