How Far Will the Dollar Appreciate?

Due to financial stress and lack of recovery in Europe and Japan, and a decline in the fortunes of commodity exporting countries the dollar is rising above other currencies. It typically has traded between 70 to 90 points in the past 10 years and is now at 90 points for the DXY indicator.

In the early 1980’s it went up, from after trading in the 85 to 100 range, to 162 because our interest rates were much higher than other countries.

Part of the reason the DXY went up so much in the 1980’s was because of the “money illusion” where naïve investors look only at nominal yields (instead of real yields) which were extremely high then. Today’s yields, though four times greater than Germany’s, are still, in absolute terms, not very high. Today the ten year German government bond yields 0.55% and our ten year Treasury yields 2.2%. If our Treasury yield drops to match Germany’s then the 10 year bond price will go up about 13%. If a similar thing occurs to 30 year bonds then they would experience a price appreciation of roughly 30%. If investors act in anticipation of these price increases then they will sell Euros and buy dollars and invest in U.S. Treasuries. This inflow of foreign money could make the dollar go up. An over-simplistic view would be that if a bond is going to appreciate 30% then perhaps it might be worth it for foreigners to push up the value of the dollar in an attempt to own U.S. Treasuries with a price appreciation of the dollar roughly paralleling that of the price appreciation of the actual Treasury bond. If the dollar almost doubled in the early 1980’s as a result of the U.S. offering the highest bond yields then there is a precedent for a similar event today. A similar experience occurred in the dotcom boom of 2000 when a global appetite for U.S. tech stock made the DXY dollar index go to 120. Of course there are many economic cross currents that could mute the potential 30% increase in the dollar. As it rises then foreigners will be less able to buy our exports or visit the country thus cooling down the increase. Also currency speculation is notoriously difficult as politicians frequently seek to devalue suddenly without warning. A country with rapid currency appreciation may seek to stop appreciation so as to avoid losing export orders. This would be easiest to do by instituting some type of global charitable Quantitative Easing by the U.S. Federal Reserve. For example if a global crash occurs the Fed could print money and buy foreign currency thus selling dollars which would slow down the rate of appreciation of the dollar. The Fed is not allowed to do this but in an emergency they will find a legal loophole. Perhaps they could lend it to the ECB in a “currency swap” operation.

The Emerging Market countries have borrowed in dollars and will be hurt if they have to pay back loans at 50% higher cost than expected, (just when they are experiencing less income from a decline in the commodities industry) assuming the dollar rises from its low of 70 a few years ago to about 105 points; if it goes to 120 that could be a 71% increase which would throw EM countries into a global recession. They have a higher growth rate than developed countries, so if their growth becomes negative then the world will surely slip into a recession. After all, the last one was six years ago so in another year it may be time for a new one.

Ironically as the U.S. becomes close to being the only successful, prosperous region in the globe then other countries can’t afford to buy our exports and our success ends up triggering a global recession in a Hyman Minsky moment.

Investors need independent financial advice about the risks of investing. I wrote an article “Dollar’s strength may trigger global recession”.

 

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Don Martin

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