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Year-end review of the dollar: very weak

As the year winds down and we survey what's done well and what hasn't, the dollar stands out as not having done much on balance. It's down against the yen, up against the euro, down against the loonie, down against the aussie, and up against the pound. It's about unchanged against a basket of major currencies, weaker against a large basket of currencies, and weaker against the Indian and Chinese currencies. On an inflation-adjusted basis, against a very large basket of trade-weighted currencies, the dollar is weaker on the year. From a long-term perspective, the dollar stands out as very weak, and by one measure (arguably the best) it is now as weak as it's ever been.

This is perhaps the most popular measure of the dollar's value, and it compares the dollar to the Euro, Yen, Pound, Canadian Dollar, Swedish Krona, and Swiss Franc on a trade-weighted basis. The dollar by this measure is up 1.5% for the year, but that is small consolation given how weak it remains.

This second chart compares the dollar to a very large basket of currencies on a trade-weighted basis. Pretty much the same story as the first chart: the dollar is very weak.

The third chart (arguably the best measure of the dollar's overall value against other currencies, and my personal favorite) compares the dollar to a very large basket of trade-weighted currencies, and is adjusted for inflation differentials. This corrects for those situations where high-inflation currencies fall by a lot against the dollar in nominal terms; if not corrected for inflation differentials, the effective decline in those currencies is exaggerated, and thus the dollar comes out looking stronger than it really is. This index shows the dollar has—for the fourth time since 1973—hit an all-time low.

This next chart (above) shows the dollar vs. the euro, using a synthetic value of the euro (based on the DM) for the years prior to 1999. In this and in the charts that follow, the green line is my estimate of the purchasing power parity (PPP) of the dollar—the exchange rate that would equate prices between the two countries. This value changes according to relative inflation differentials. In the case of the euro, the PPP value of the euro has been trending stronger since the 1970s because inflation in Europe has for the most part been lower than inflation in the U.S. According to this chart, at today's value of 1.34 dollars per euro, the euro is about 15% "overvalued" against the dollar. That is a way of saying that a U.S. citizen traveling in Europe is likely to find that, on average, things cost about 15% more in Europe than they do in the U.S. Note that the dollar has been much weaker against the euro than it is today, and the reason for this is that the euro is suffering from fears that sovereign defaults among its member nations (e.g., Ireland, Portugal, Spain, and Italy) could result in a breakup of the euro. Personally, I think that is a very unlikely event, but in the meantime the perceived threat to the euro ends up being to the advantage of the dollar.

This chart (above) shows the dramatic gain in the value of the Canadian dollar vs. the US dollar. Relative to its PPP, the loonie today is almost as strong as it has ever been. US tourists are likely to find that traveling in Canada is quite expensive these days. Strong commodity prices have helped support the loonie, as has its central bank. Monetary policy in Canada has been less volatile than in the U.S., and Canada has apparently avoided a housing and bank bust.

The Australian dollar (above) has also benefited enormously from strong commodity prices, which in turn have boosted its resource-based economy, with the result that it is now about 50% "overvalued" relative to the dollar by my calculations.

The yen today is trading right around its strongest level ever (in nominal terms) against the dollar. But in inflation-adjusted terms, the yen is not as strong today as it was in 1995, when it was briefly "overvalued" against the dollar by almost 100%. By my calculations, today the yen is about 50% "overvalued" against the dollar. The long-term strengthening of the yen against the dollar is explained by the fact that Japan has had much lower inflation than the U.S., and that in turn is the result of Japan's chronically tight—to the point of being somewhat deflationary—monetary policy.

The pound at $1.56 is only about 12% "overvalued" by my calculations, and it has weakened considerably in recent years. (I was unlucky to have my daughter studying in London during the years when the pound was the strongest.) The long-term trend of the pound against the dollar has been down, and that is explained by the fact that inflation in the U.K. has been consistently higher than in the U.S.

I note that all of these major currencies are "overvalued" relative to the U.S. to some degree. That's the flip side of saying that the dollar is "undervalued" against all these currencies, and that confirms the message in the first set of charts above, which is that the dollar is generally very weak.

This last chart compares the dollar (blue line, inverted) against one measure of commodity prices. Note how the correlation between the two has been fairly strong in the past decade—dollar weakness corresponds to commodity strength, and vice versa. This is one way of showing that there is a monetary explanation for rising commodity prices: a weaker dollar buys less of other currencies and fewer commodities. Dollar weakness, in turn, is ultimately the responsibility of the Fed: keeping interest rates too low results in an effective over-supply of dollars, and a loss of the dollar's purchasing power.

Bottom line: the dollar is unequivocally weak against many objective standards (e.g., gold, commodities, and other currencies). It's about as weak, in fact, as it has ever been, and its prospects are grim, since the Fed has vowed to remain ultra-accommodative for a long time to come. If there is a silver lining to this dark dollar cloud, it is that with the dollar at extremely weak levels, perhaps all the bad news is priced in. If so, then the dollar becomes quite "vulnerable" to any good news, or simply to a failure of the expected bad news to show up. I'm on record as predicting the dollar will strengthen against most major currencies this coming year, and I sure hope I'm right, since further dollar weakness from this point would be very unpleasant, if not inflationary.

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