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Why a stronger dollar is not a problem (2)

I've been showing this chart off and on for the past year, with an extensive post on the subject last December, which by the way deserves re-reading. What's noteworthy now is the breakdown in the strong negative correlation (~0.95) between the dollar and equities that persisted from Sep. 2008 through Nov. '09. While most pundits viewed the negative correlation as symptomatic of the "carry trade," I thought it had a lot to do with the demand for money. The dollar was on the receiving end of the flight to safety that was precipitated by the financial crisis of '08, and the reversal of that move is what pushed the dollar down and equities up. Dollars that were hoarded in late '08 and early '09 were subsequently released back into circulation, and this helped spark a recovery both here and abroad. A weaker dollar and a stronger economy thus went hand in hand.

What we've seen since last December is a stronger dollar and a stronger equity market. (Note that the chart plots the dollar on an inverted scale.) As I said back in December, this suggests that the economy is improving on its own merits. What's good for the economy is also good for the dollar.  People were very scared a year ago, but that fear has been slowly waning for many months; as fear subsides, the price of risky assets rises, and spending and economic activity improve as well. A stronger economy improves the valuation of the dollar, because a) it improves the expected returns on equities, and b) it means the Fed is less likely to be too easy for too long.

Parenthetically, a good friend asked me over the weekend why the passage of healthcare is being accompanied by higher equities, when it portends more government control of the economy and higher tax burdens. Shouldn't the market be depressed by the passage of a bill that calls for a gigantic expansion of the role of government in the economy? Here are some possible answers: a) the market doesn't believe the healthcare bill will survive the numerous challenges it faces; b) the huge opposition to the bill which was evidenced around the country and in every public opinion poll is a good sign that the era of Big Government has hit the high-water mark; c) the market is still trading at very depressed levels (as I have argued repeatedly); d) the market's rise over the past year has been driven primarily by the huge change between the market's initial expectations and today's reality (i.e., one year ago the market expected a gigantic depression, and instead we find ourselves in a recovery); and e) the healthcare bill won't translate into meaningful changes in policy or taxes for several years at least, so for now the dominant factor driving the equity market remains the underlying improvement in the economy.

If I could summarize all the possible reasons for why the dollar and the equity market have moved higher of late, it would be this: both the dollar and equity valuations remain depressed from an historical perspective, but the dominant changes on the margin have been positive for the economy (a recovery instead of a depression), while the passage and implementation of the healthcare bill is still very much up in the air.

UPDATE: To back up my inclination to view positively the current state of affairs, some quotes from George Will's recent column:

"And everybody praised the Duke, Who this great fight did win."

"But what good came of it at last?"

Quoth little Peterkin.

"Why that I cannot tell," said he, "But 'twas a famous victory"

-- Robert Southey, "The Battle of Blenheim"

Now, perhaps, comes Thermidor.

That was the name of the month in the French Revolutionary calendar in which Robespierre fell. To historians, Thermidor denotes any era of waning political ardor. Congressional Democrats will not soon be herded into other self-wounding votes -- e.g., for a cap-and-trade carbon-rationing scheme as baroque as the health legislation. During the Democrats' health-care monomania, the nation benefited from the benign neglect of the rest of their agenda. Now the nation may benefit from the exhaustion of their appetite for more political risk.

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