Higher dollar will cause lower stock prices

September 3, 2008

The dollar is rising, and while reappraisal of the global economy may lead to further strength for the dollar in the coming 6-12 months, it’s important that we put the macro picture into perspective when analysing the direction in the forex markets.

 

When there is no excessive divergence in interest rates or central bank policies, one should expect currencies to perform according to the underlying fundamental strength of the respective economies.

 

Such is the case between Europe and the US, where the rate differential is too small to override macroeconomic concerns. Since the introduction of the Euro, and except for a brief period during the global stock market bubble, the behaviour of the euro-dollar pair has beem based on fundamentals. The overextended finances of both the public and private sectors in the US contrasts unfavorably with the balanced current account situation of Europe, the relatively less leverage of its citizens, and the much better fiscal discipline of the governments. Until recently even Spain’s government could boast of a singnificant fiscal surplus, and on the whole the stringent requirements of the euro area treaties, and continuous urging by the ECB for fiscal responsibility allowed Europe better fundamentals than those of the overextended, overleveraged US. There’s, in short, every reason to be negative on the dollar versus the euro, based on the fundamentals of the two economies: The dollar is just another word for leverage and indiscipline.

 

When the Fed began reducing rates in September 2007, in spite of external financing concerns, and fears of inflation, investors and speculators around the world reacted by buying commodities and selling dollars, partly in anticipation of decoupling, and partly to profit from the dollar-negative momentum. And they were justified in their pessimism for the US dollar, except for one difficulty:

 

The USD is the world’s currency for trade: it’s supply will be ample during times of increased economic activity, as the supply of USD from exporters to the US, and also from global players such as hedge funds and mutual funds widely exceed the USD demand for imports such as oil, copper, and finished goods. Thus, as greed, and the quest for yield cause ever greater amounts of US dollars to be exchanged for other currencies, the buoyancy of the global economy will also draw down the value of the dollar, especially when the medium term fundamentals of the US economy are as weak as detailed in the previous paragraph.

 

When however, the opposite happens, and global demand contracts, as the growth of demand for commodities, the volume of international trade is in danger of declining, there will be less circulation of the dollar, and the currency of international trade will also see increasing demand, just as the supply of dollars from international economic actors contracts as a result of the same reasons: the prospect of weaker economic activity will cause repatriation flows, extracting dollars from the global financial system, and in the worst cases, as we’re witnessing now, a shortage of the US currency.

 

This then explains why the discrepancy between the value of oil and the euro versus the dollar created an arbitrage opportunity, provided that the investor sees them as different faces of the same investment paradigm. Indeed until recently the fluctuations of euro-dollar parity, and the oil price showed a close correlation even of intraday movements. It was only natural that one would follow the other.

 

Now, if rising dollar means less global economic activity, at a time when internal demand in the US is likely to shrink as a consequence of deleveraging, and rising unemployment, then how do we explain the recent rise in stock prices? Rising dollar and rising yen are the hallmarks of pessimism and fear; if US and Japanese investors are withdrawing funds from overseas, putting it in bonds and cash, is it possible to interprete this phenomenon as being positive for financial markets?

 

While the disinflationary effect of the rising dollar is welcome, one must remember that even before the recent turmoil, there were significant inflationary pressures in the world economy. The era of cheap Chinese labour is already over – inflation is now a structural problem, not a temporary one.

 

We’re likely to see continued falls in the stock markets in the next few weeks, and months.

Advertisements

One Response to “Higher dollar will cause lower stock prices”

  1. […] term geopolitical issues and inflation will determine the dollar’s course. As I noted in a previous post, crises of confidence can create adverse feedback loops, and this will probably add to the strength […]

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: