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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.

Impressive signs of economic strength

It's said that "Dr. Copper" is the commodity that is best at diagnosing the health of the economy. If that's true, then the global economy is really humming along, since copper prices are now hitting new, all-time highs.

The CRB spot index measures the price of a collection of very basic, non-energy industrial commodities. It too is at a new all-time high, suggesting that global manufacturing activity is moving forward in robust fashion. Most of the commodities in this index do not have associated futures contracts, so speculative hoarding is not liable to be a distorting factor.

The chart above is the Chicago Purchasing Manager's Index, and it has reached a 22-year high; the employment component of the same index has reached a new post-recession high. Moreover, the December Milwaukee PMI released today rose much more than expected.

The chart above shows the average price of regular gasoline according to the AAA survey, and it has reached a new, post-recession high.

The Korean stock market (KOSPI) is within inches of a new all-time high (the all-time intra-day high was 2085 in Nov. '07).

The chart above shows Commercial & Industrial Loans, a good measure of bank lending to small and medium-sized businesses. Loans have stopped declining and are now rising, a sign that banks have eased their lending standards and/or businesses are once again seeking to borrow more. In either case, that bodes well for future economic growth.

Some of the action in the above charts may be due to accommodative monetary policy and rising inflation pressures, but it's equally likely that they reflect improving economic activity. There are certainly pockets of weakness left, particularly in the housing market, but it's hard to ignore the growing list of signs of strength.

Unemployment claims fall dramatically

If people filing for unemployment claims is bad news, then the news from the labor market is certainly a whole lot less bad. Seasonally-adjusted claims have fallen dramatically in the past month or so (top chart) because not as many people are being laid off as would normally be the case around the end of the year (second chart, showing actual, non-adjusted claims—note the huge spikes that occur around year-end, and how small the spike has been this year). This recovery has been sluggish compared to others, but the decline in claims is now more impressive than it was 18 months into the recoveries that started after the 1990 and 2001 recessions.

One way to interpret this is that companies are laying off fewer people because they were already running a tight ship, having laid off tons of workers over the previous year in order to cope with uncertainty and a weaker economy. The economy was braced for the worst, in other words. That would imply that any unexpected uptick in the economy's health, now that uncertainty over future tax rates has been mostly resolved, should translate rather quickly into new hiring. That's been the story of this recovery: the reality has almost always proved much better than the fears. The employment situation should be improving in a positive fashion in coming months, with job gains coming in above expectations.

No improvement so far in housing prices

The October Case Shiller home price data released today seem to have revived the calls for a housing double-dip. Prices were a bit lower than expected, and according to the broader measure of prices (a composite of 20 large markets), they are now at a new post-recession low in real terms (but only by a hair). But whether the recent modest decline in prices is the beginning of a new major downturn in prices remains to be seen; it could be just temporary, and in any event it represents price action from the third quarter of last year, which was a period we now know was somewhat of an economic soft patch.

The bigger picture is that both indices show housing prices have fallen about 35% from their 2006 highs in major markets, which also happened to be the areas with the most froth at the peak. Coupled with an almost 25% decline in mortgage rates since 2006, the effective cost of buying a house dropped by some 50% in just four years. The real question today is whether that price drop is sufficient to elicit enough buyers to purchase the large (but presumably still shadow) inventory of foreclosed homes that are likely to be hitting the market over the next year. Even as housing prices have declined significantly, new household formations have continued and the population has grown.

Have prices fallen enough to clear this market? I continue to think they have. The economy is clearly on the mend, and incomes and jobs are rising. New home construction has declined to de minimis levels. Perhaps there is some further weakness in store, but surely we have seen the lion's share of the weakness by now. It hasn't happened before, but that is no reason it can't: housing is likely to be supported by an expanding economy this time around, whereas before it was housing that gave an important impetus to the economy. New jobs and economic growth can take care of a lot of excess housing inventory, and easy money, relatively low mortgage rates, and a gradual easing of lending standards can take care of the rest. It's time to put concerns about the housing market on the back burner.

Predictions for 2011

Predicting the future back in late 2008 wasn't too difficult, because the market was priced to Armageddon; I thought we would survive, and I turned out to be right. Last year it was more difficult to predict the future, and while I got most things right I made some critical mistakes, mostly concerning the Fed and inflation. This year is going to be even more difficult, because the difference between what the market expects and what I expect to see isn't nearly as great as it was one or two years ago.

From an investor's perspective, the important thing about forecasts is not whether you get the exact number right (e.g., whether economic growth is going to be 3.5% or 3.8%), it's whether you get the direction right relative to what the market is expecting (e.g., whether growth is going to be stronger or weaker than the market expects). If the market expects 3% growth and you correctly forecast 3% growth, that isn't worth much since you are unlikely to make much money by betting with the market.

With those caveats in mind, my outlook for 2011 is shaped by a belief that the economy will do somewhat better than the market expects, that the Fed will be less easy than the market expects, and that inflation will be somewhat more than the market expects. I held the same general view a year ago and turned out to be wrong on the Fed and inflation, but I don't see any reason to change now. Monetary policy is notorious for acting with long and unpredictable lags, and policy has moved much further in the direction of stimulus in the past year, so at some point we could see the fruits of monetary ease come true with a vengeance. This is no time to get wobbly on the Fed's ability to get what it wants (i.e., higher inflation).

So here we go:

The economy will grow by 4% or more in 2011. I think the market is priced to the expectation that growth will be around 2.5-3%, slightly better than the "new normal" economy scenario that has been all the rage in the past year or so. I'm more optimistic, for a number of reasons. Most important is the 180ยบ shift in the direction of fiscal policy that started with the November '10 elections—that's very good news for the economy. Washington is now much more friendly to capital and to the private sector, and those are the folks who create real jobs and real growth. Going forward, fiscal policy is likely to promote the growth of the private sector at the expense of the public sector. Taxes are not going to rise as so many had feared, and we may even see some cuts along with a simplification of the tax code. Many worry that cutbacks in federal, state and local government spending will prove very painful for the economy as a whole, but I disagree. One reason the economy has experienced a very sluggish recovery is precisely because there has been way too much growth in the public sector in recent years. Feeding resources to the public sector is a recipe for disappointing growth, and the experience of the past two years is proof of that proposition. So it only stands to reason that reversing the tendency to fiscal profligacy should be stimulative: fiscal austerity is bad for the public sector but good for the private sector. Given the improvement in unemployment claims of late, I expect to see an increasing number of new jobs over the course of the year. And the improvements already evident in autos, exports, mining and manufacturing can generate a positive feedback that lifts most other sectors. The forces of recovery are alive and well, and growth can trump a lot of the lingering problems we still have (e.g., underwater mortgages, state and local insolvency, high unemployment).

Inflation will trend slowly higher. Inflation is already a mixed bag, with the CPI and the PCE deflator having trended lower in the past year and the GDP deflator having trended higher. I would expect to see more uniformity this coming year, with all inflation measures showing a rising trend, albeit only a moderate one. Nevertheless, inflation is likely to be more of a problem than the market currently expects. TIPS currently are priced to the expectation that the CPI will be about 1.3% next year, compared to 1.1% over the past year. I see lots of signs that money is in abundant supply, and that is a good indicator that inflation pressures are on the rise: gold and commodity prices are soaring, the dollar is very weak, and inflation in China—a canary in the coal mine since China is tied to the dollar and thus is experiencing the same monetary policy as we have—is on the rise.

The Fed will raise rates sooner than the market expects. Fed funds futures currently are priced to the expectation that the Fed will raise the funds rate to 0.5% next December. I think it will happen sooner. The combination of a stronger-than-expected economy and signs of rising inflation will motivate the Fed to reverse its quantitative easing program sooner than most expect. Ending and/or reversing quantitative easing does not, however, equate to monetary policy that is a threat to growth; it will be a long time before the Fed raises rates enough to choke off growth.

The housing market will be showing signs of life by the end of the year. Housing still looks weak, and the weakness will probably last a bit longer (e.g., a modest further decline in prices, and flat construction activity). But with the economy picking up speed, money in abundant supply, and ongoing growth in the population and household formations, I think the housing market could be on the mend by the end of the year.

Interest rates on Treasury bills, notes and bonds should be higher than they are today, and higher than the market currently expects. Treasury yields out to 10 years are driven by expectations of future Fed policy, so if I'm right about the Fed raising rates sooner than the market currently expects, this should result in higher rates across the yield curve. Currently, according to implied forwards, the market expects to see 3-mo T-bill yields at 0.85% by the end of next year, with 2-yr T-notes at 1.6% and 10-yr T-note yields at 3.9%. Betting that 10-yr yields will rise from their current level of 3.4% is not enough, however; shorting the 10-yr incurs a carry cost that must be made up by falling prices. 10-yr yields need to be at least 3.9% for a short position in the 10-yr to be profitable. Higher yields on risk-free Treasuries will not threaten the economy, since they will be the result of a stronger economy. Higher yields on cash will be a net benefit to the household sector, since it holds more floating rate assets than floating rate liabilities.

MBS spreads are likely to widen over the course of the year. The main impetus for wider MBS spreads next year is likely to come from an across-the-board increase in the extension risk of MBS as Treasury yields rise. Mortgages, which currently behave like intermediate-maturity bonds, are at risk of becoming long-term bonds as interest rates rise and refinancing dries up.  It's possible, however, that MBS could still provide a reasonable rate of return, and/or beat the returns on comparable Treasuries if spreads fail to widen significantly.

Credit spreads are likely to decline gradually over the course of the year. Easy money and a strengthening economy add up to a perfect environment for borrowers. Easy money adds fuel to corporate pricing power, and improved cash flows are a boon to borrowers, especially the most indebted ones, and that in turn means lenders will be rewarded by today's still-relatively-high yields and lower-than-expected default rates. High-yield bonds should be the biggest beneficiaries of tighter spreads. If Treasury yields rise enough, however, spreads on higher quality bonds are not likely to be able to absorb the full brunt of rising market rates, meaning there is the risk of mark-to-market losses on corporate bond prices. 

Equity prices are likely to register gains of 10-15% next year. I see no signs that the equity market currently is overvalued. Corporate profits have been very strong, and PE ratios remain relatively subdued. A stronger economy should continue to boost profits, and enhance investors' confidence in the outlook for future earnings, resulting in at least a moderate rise in equity prices.

Commodity prices will continue to work their way higher over the course of the year, buoyed by ongoing improvement in global economic growth and accommodative monetary policy. In real terms, commodity prices are still far below the highs they reached in the inflationary 1970s. Oil prices are likely to drift higher as well, and at these levels still do not present a serious threat to economic recovery. Commodity investing, however, is fraught with perils, particularly the fact that commodity speculation can result in backwardated futures prices, and those act to limit the speculative returns to commodity investing.

Emerging market economies are likely to do somewhat better than industrialized economies. These economies tend to thrive in an environment of easy money, rising commodity prices, fiscal policy reform, and ongoing globalization.

Gold will probably move higher, mainly since monetary policy is very likely to remain accommodative. But the potential for a significant decline—should, for example, the Fed surprise everyone and tighten early—is enough to keep me out of the gold market. Gold is a highly speculative investment at this point and should be approached with extreme caution.

The dollar is likely to move higher against most major currencies, and hold relatively steady against emerging market and commodity currencies. Currently, the dollar is so weak against most major currencies, both nominally and in inflation-adjusted terms, that even modest upside surprises such as higher-than-expected U.S. growth and/or an earlier-than-expected reversal of quantitative could prove very bullish for the dollar. Put another way, so much bad news is already priced into the dollar that I think its downside potential is limited.

Full disclosure: I am long equities, short Treasury bonds, and long high-yield debt at the time of this writing.

Why a lack of confidence is good

The December reading of the Conference Board's measure of consumer confidence was weaker than expected (52.5 vs. 56.3). Is that cause for concern? Hardly. As this long-term chart of the series shows, monthly volatility in the index is the norm, and the latest wiggle can hardly be seen. The only message to be found in this series is that consumers are still very un-confident. This is hardly surprising, since confidence almost always lags what is going on in the real economy. For example, it took about 3 years for consumers to begin feeling better about the economy following the recession of 1990-91. Plus, consumers don't usually get depressed until recessions are well underway.

The fact that consumer confidence remains low is a good reason for investors to be optimistic, because it means there is a lot of room for improvement. The rally in equity and corporate bond prices that began almost two years ago has been driven fundamentally by the discovery that the future was not turning out as bad as everyone had thought. In early 2009, markets were priced to the expectation of a very deep depression and years of deflation. Instead, we find the economy recovering and inflation low but not negative. Positive shocks such as this (the reality turns out better than the expectation) are what drive risky asset prices higher.

By the time everyone recovers their confidence in the future, prices will be a lot higher than they are today. You can't wait for the news to turn good before betting on higher prices. The current low level of consumer confidence is also a reason to doubt the warnings being issued by a number of pundits that the stock market is over-bought and frothy.

Investors—those with real skin in the game—are usually better at discerning the state of things. This chart of option-adjusted spreads on corporate debt is a good measure of how confident investors are about the credit-worthiness of corporate borrowers, and about the future of the economy. Spreads have come way down from their highs, as investors have realized that the world was not coming to an end, but spreads are still quite a bit above where they would be if the world were back to "normal" and confidence in the future were high. I think this jibes well with the consumer confidence numbers, with both confirming that there is still a good deal of caution and fear out there. We're a long ways from seeing speculative froth or another asset price bubble.

Federal revenue growth is impressive, believe it or not

It strikes me that the recent growth in federal tax revenue is not widely nor sufficiently appreciated, probably due to the pessimism that pervades just about every long-term outlook these days. The chart above, which plots the 6-mo. annualized growth in rolling 12-mo. federal revenues, shows that tax receipts are now rising at double-digit rates. Total federal receipts over the 12 months ended November '10 are more than 10% above (annualized) total receipts over the 12 months ending May '10. This is shown in the chart below: monthly revenues this past year have been consistently higher than they were a year ago. All that progress, without raising a single tax rate! In fact, as the charts above and the second one below document, the major determinant of federal revenues is the business cycle, not tax rates. During recessions, revenues collapse, and during recoveries revenues rise, usually faster than the growth in nominal GDP. Now that we are 18 months into a recovery, it is not surprising at all that tax revenues should be rising at a much faster rate than GDP.

The chart below helps put this into perspective. For 50 years, from 1955 through 2005, revenues on average rose at the same rate as nominal GDP (i.e., revenues as a % of GDP were relatively unchanged), even though tax rates changed dramatically. Revenues are still at a post-war low relative to GDP, of course, but that is mainly because this recession has been deeper than most others.

As the economy picks up, tax receipts accelerate because more people work and pay taxes, corporate profits rise, and incomes rise in our highly progressive tax system—the most progressive of any advanced economy. Recoveries always result in a huge increase in tax revenues. Unfortunately, when revenue growth is at its strongest, politicians inevitably figure out how to spend money even faster.

There is every reason to think that federal (and state and local) revenues will continue to grow at a relatively high rate as long as the economy continues to recover. Balancing the budget doesn't require higher tax rates, it just requires spending restraint and pro-growth policies. Holding spending constant, and assuming revenues grow at their current rate, the federal budget would be balanced in 5-6 years. If the new Congress can't make a significant move in this direction (i.e., holding the line on spending and keeping tax rates as low as possible), they deserve to be trounced in the next election.