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Reflections on the dollar's weakness

With the Fed's latest data release, it's official: in inflation-adjusted and trade-weighted terms (arguably the best way to measure the dollar's true purchasing power overseas), the dollar is now weaker than it has ever been.

Against a relatively small basket of major currencies (above chart), and not adjusted for inflation differentials, the dollar has yet to hit new all-time lows, but it's very close.

What does the dollar's unprecedented weakness mean? A lot of things:

It reflects the world's deep mistrust of our monetary and fiscal policies. In a sense, the dollar's value is akin to the price that foreigners are willing to pay to gain access and exposure to the U.S. economy. The very weak dollar is a sign that the U.S. is a very unattractive place to do business these days.

The Fed is supplying more dollars to the world than the world wants to hold. As a corollary, the Fed is setting U.S. interest rates at a level that is lower than they should be to balance the world's demand for dollars with the supply of dollars.

U.S. exporters may get a temporary boost, since a cheap dollar makes it easier for them to undercut foreign competitors. But the cheap dollar will tend to boost the price of all imported goods, and that in turn will increase the cost of living for everyone. Eventually, higher inflation will erode whatever advantage exporters might enjoy today. You can't devalue your way to prosperity.

U.S. tourists will find that most overseas destinations are extremely expensive; combined with expensive energy, this is likely to curtail many summer travel plans.

Foreign tourists will find that the U.S. is one of the cheapest destinations in the world; this is likely to boost the U.S. tourism industry.

Foreign holders of trillions of dollars of U.S. debt are losing money daily as the dollar declines against their currencies. Over the past year, for example, the Chinese yuan has appreciated by 5% against the dollar, thus reducing the value of China's Treasury holdings by 5%; that's roughly equivalent to two years' worth of interest payments. China doesn't have much of an alternative, though, since unloading a significant portion of its U.S. debt holdings would likely depress the dollar even more. Foreigners in aggregate have huge exposure to the dollar (the flip side of our multi-year trade deficits is a multi-year inflow of foreign capital); so huge, in fact, that they have little alternative but to grin and bear it.

If foreigners were to sell a significant portion of their U.S. holdings, they would not only lock in huge losses, but they would also have to find something here on which to spend the dollars they no longer want. Any net capital outflow would perforce require a net trade surplus. A mass liquidation of U.S. security holdings by foreigners could translate into a gigantic increase in U.S. exports. Alternatively, a significant portion of any mass liquidation of Treasuries by foreigners could find its way into our equity and property markets. Treasuries are trading a unusually high valuations (i.e., very low interest rates), while equities are not overvalued (e.g., PE ratios are below average), so swapping out of Treasuries and into stocks and real estate might make a lot of sense to many foreign investors. To the extent this happens, Treasury yields and equity prices might rise simultaneously.

Foreign investors are finding that U.S. real estate is very cheap. Since the peak of the housing market in early 2006, prices have fallen by about 30% according to the Case Shiller data, while the dollar has declined by about 15%. Combined, that has reduced the effective price of the typical U.S. home by 40% in the eyes of foreign investors. Foreign demand for U.S. real estate likely is playing an important role in stabilizing the U.S. property market.

With the dollar trading at all-time lows, a decision to sell the dollar here requires a firm conviction that the bad news that is already out there (e.g., trillion-dollar deficits, and a massive expansion of bank reserves that could fuel a huge increase in inflation) is going to get even worse—not only are things as bad as they've ever been, but we ain't seen nothin' yet.

With the dollar plumbing all-time lows almost daily, it is no secret that the outlook is grim. Dollar sentiment is extremely depressed. The dollar could therefore benefit from any indication that conditions are not as bad as everyone thinks. The mere absence of bad news could be very good news for the dollar. If the news turns positive (e.g., Congress finds a way to restore fiscal sanity without big tax hikes, and/or the Fed raises interest rates convincingly) then the dollar could have massive upside potential.

But as my mentor Art Laffer taught me, fiat currencies—unlike gold and real estate—have no intrinsic value. They can (and many do) decline forever.

Feel free to add more reflections in the comments.

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