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Dollar update: still very weak

Since mid-November, the dollar is up about 18% vs. the yen, down 2% against the euro, and up 5% against Sterling. But against a broad basket of currencies, the dollar is still very close to its all-time lows.


This chart shows the inflation-adjusted, trade-weighted value of the dollar relative to two baskets of currencies, as calculated by the Fed, as of the end of January. Take your pick: these are arguably the best measures of the dollar's effective value vis a vis other currencies.

Although there has been a lot of currency volatility of late, particularly in regards to the value of the yen, the dollar remains very weak from a long-term historical perspective. It is at least encouraging that on the margin, the dollar has been eking out some gains. By the Fed's broadest measure, the dollar's purchasing power relative to other countries is up about 4% from its 2011 low. My take on this is that conditions in the U.S. (e.g., fiscal and monetary policy, economic growth) haven't turned out to be as bad as the market had expected.

Once again, I think this is evidence not of increasing optimism, but declining pessimism. The dollar is still very weak, and that is a sign that there is lots of bad news still priced into the dollar.

From an investor's perspective, this argues against taking on significant exposure to non-dollar currencies, unless you are very bearish on the prospects for the U.S. economy. Foreign currencies on average are very expensive at today's levels.

Inflation and deflation have coexisted for 18 years

Inflation by almost any measure remains benign, in the range of 1-2% over the past year. But this relative tranquility masks huge shifts in relative prices: durable goods prices have been falling for the past 18 years, while the prices of services and non-durable goods have been rising. We live in a world where inflation and deflation appear to coexist. 


This first chart compares the year-over-year change in the headline and core (ex-food and energy) version of the Personal Consumption Deflator, which is generally considered to be a broader and more accurate measure of the prices paid by the great majority of consumers than the CPI (which is narrower and slow to change as consumption habits change). By either measure, inflation is within the Fed's target range. 


This next chart shows the level of the three main components of the Personal Consumption Deflator, starting from the end of 1994. I chose that date because that was the beginning of the only sustained period of decline of any component of the Personal Consumption Deflator on record, and as you can see, the durable goods component has been declining steadily every since. It is probably not a coincidence that 1994-95 marked the beginning of China's emergence as an economic and exporting powerhouse. China's dramatic growth, industrialization, and cheap labor have undoubtedly contributed significantly to the decline in durable goods prices over the past 18 years. The whole world is better off, because incomes have been rising significantly relative to the prices of durable goods. If you use the services sector price index as a proxy for wages, then wages have risen 126% relative to durable goods prices in the past 18 years. This is unprecedented.

Put another way, an hour's worth of work for the average person now buys more than twice as much in the way of durable goods. Billions of people now walk around with powerful computers in their pockets, linked to a global network that gives everyone access to just about all the information in the world, anytime, anyplace. This is prosperity and progress on a massive scale.

No wonder the debate rages over whether we suffer from too much or too little inflation. But in the end, it can't be a bad thing that wages continue to rise while computers, TVs, cameras, phones, etc., continue to fall, even as they become more and more powerful.

Manufacturing outlook improves somewhat

The February ISM manufacturing indices were generally stronger than expected and consistent with a decent pickup in economic growth in the current quarter compared to the dismal growth of last quarter.

The overall manufacturing index came in at 54.2 vs. an expected 52.5. As the chart above shows, this is consistent with economic growth in the current quarter of 3-4%, a big jump from the 0.1% growth rate of the fourth quarter. This view is supported by the New Orders index, which has rebounded significantly this year from 50 in December to 57.8 in February.


The Export Orders index picked up nicely, a welcome sign that the troubles in the Eurozone, which has been in recession for the past year, are not a significant drag on the U.S. economy. Globally, conditions outside the Eurozone appear to remain healthy.


The Prices Paid index remains at a level that is consistent with ongoing, mild inflation.


The Employment Index is mildly positive, but does not point to any meaningful strengthening in manufacturing in the near future.


According to the ISM indices, the outlook for the U.S. economy remains substantially better than for the Eurozone economy. Eurozone manufacturing reflects an ongoing mild recession; the best that can be said is that conditions in the Eurozone are not deteriorating further.

U.S. production of crude oil surges

I must echo Mark Perry on this (check out his latest post for lots of juicy details), since it represents a big positive change on the margin that supports the outlook for the U.S. economy.


U.S. crude oil production is up 22% in the past year, and has risen by an astounding 34% in the past four years. This is more than a recovery from recession, this is effectively a whole new industry that is being built on the back of new drilling technologies.


Along with the rise in crude oil production which started 2008 has come a virtual gusher of natural gas, which in turn has resulted in a huge decline in natural gas prices. As the chart above shows, from their peak in 2008, natural gas prices have fallen almost 75%. Crude oil is largely fungible and thus determined by global market forces, so its price hasn't fallen much, but natural gas is not easily fungible on a global scale (it has to be compressed and shipped) and so U.S. gas prices have fallen significantly.


As this next chart shows, natural gas has now become extremely cheap relative to oil. This has given U.S. manufacturers who use large amounts of energy a significant natural advantage relative to those of other countries, not to mention giving consumers in many areas of the country a big break on their heating bills. These are transformative changes in the U.S. economy which are extremely positive for the future.

What claims say about investment strategy

First-time claims for unemployment remain in a downtrend, a clear sign that the fundamentals of the labor market continue to improve. This is the natural progression of any economic recovery, and strongly suggests that the economy remains in recovery mode, however weak it might be. 


The chart above shows the long-term trend of non-seasonally adjusted claims (white) and the 52-week moving average (purple). The pattern is clearly down, although the rate of decline appears to be slowing—which is natural, since claims are unlikely to ever fall much below 250K per week. At this time of the year, claims haven't been this low since 2007, a year before the recession began.


This next chart shows the non-seasonally adjusted number of people receiving unemployment insurance. Over the past year this number has declined by 1.24 million, or 18%. That is a very impressive change, and arguably one of the most impressive changes on the margin in today's economy, because it means that there are more people with a greater incentive to seek out and accept a new job. Changing incentives typically have very important impacts on the economy, and this is one good reason why the economy is likely to continue to improve, however slowly.

From the perspective of the market, which is still braced for economic deterioration, the most important thing is not the speed at which claims are falling, but the fact that they aren't rising. There is no sign here that the economy is losing vitality or at risk of slipping into another recession. Therefore, there is little justification for holding substantial assets in cash and cash-equivalent investments that pay virtually nothing, when there is a panoply of alternative investments that yield substantially more.


This is one message that the Federal Reserve is trying very hard to beat into the heads of the world's investors. It's a risky gambit, to be sure, because if substantial numbers of economic actors start getting the message, then the demand for cash and cash-equivalents will decline. This would be manifested chiefly in an increased velocity of money (money would circulate faster as people attempted to reduce their holdings of money relative to other things), which in turn would cause nominal GDP to accelerate.   Much of this acceleration in nominal GDP could come from a rising price level (i.e., inflation), and too much of this would present a real challenge to the Fed, since they would have to take measures to keep money demand from declining too much. This would entail hiking the interest rate it pays on reserves, ceasing its purchases of Treasuries and MBS, reducing (selling) its holdings of Treasuries and MBS, and/or not reinvesting principal repayments. Treasury yields could rise meaningfully.

For the past four years I've been worried about the Fed not being able to respond in a timely fashion to a declining demand for money, and thus allowing inflation to rise. Obviously, those concerns were premature, since inflation has been relatively subdued. But anyone concerned about an acceleration in nominal GDP, whether or not that meant an acceleration in inflation, would have taken the same steps that would have been appropriate had he or she merely anticipated an economic recovery, no matter how tepid. Since the market has been braced for deterioration for years now, those who have bet on recovery have been rewarded: virtually all risk asset prices are higher, and holders of non-Treasury bonds have been rewarded with substantial interest income in addition to higher prices.

I sense that we are now more rapidly approaching the point at which market psychology shifts from being passive/defensive to being more aggressive: from waiting for the train to slow down to get on board, to running to catch the train before it leaves the station. The bond market still expects the Fed to keep short-term interest rates near zero for a very long time, but those expectations could change dramatically, and the Fed's timetable for exiting QE3 could accelerate significantly. Lots of things could change, and in a big way. I'm not sure when, but more and more I think that it pays to be on the side of optimism than on the side of pessimism.

At the same time, it makes sense to retain a healthy fear of an unexpected rise in inflation, and that argues for investments in real (tangible) assets that could benefit from faster nominal growth and higher inflation. Real estate and commodity prices top the list of potential beneficiaries. Gold not so much, since I believe it has already risen by enough to anticipate a significant rise in inflation. Gold is very vulnerable to any sign of "good news," which in this case would take the form of an acceleration of the Fed's tightening timetable. That's how I read the latest decline in gold prices, as an early warning indicator of a shift in the Fed's strategy in response to improving economic fundamentals. TIPS, normally considered to be the classic inflation hedge, are also vulnerable, since real yields are very low and negative, and would likely rise if the Fed started raising rates sooner than is currently expected. TIPS investors would benefit from rising coupon payments if inflation exceeds expectations, but they would suffer from declining TIPS prices. In short, TIPS today are very expensive inflation hedges.

Business investment bounces back

Capital goods orders, a good proxy for business investment, have come roaring back in recent months after a big slump last summer. January orders were up 12.8% from September levels, and they have risen by a decent 4.7% in the past year. A few months ago, this indicator was casting doubt on the economy's ability to continue growing. Now that is no longer the case.
 

It's probably the case that last year's slump in orders reflected concerns about the looming "fiscal cliff" and the possibility of a significant rise in taxes and/or economic weakness, and that the recent jump in orders is equivalent to a big sigh of relief on the part of businesses that the issue was resolved satisfactorily.

This is yet another reminder that my thesis for the past four years still holds: with the market braced for a recession or worse, risk assets are going to rise in price as long as the evidence shows that the economy is not tanking. In other words, the equity rally that is almost four years old now has been driven not by optimism, but by a reduction in pessimism. The future has not turned out to be as bad as was expected. With this market, avoiding recession is all that matters.

More evidence that housing has bottomed

Increasingly, the evidence suggests that the U.S. housing market hit bottom sometime in the past year or two. Housing prices are now on the rise from levels that marked a huge decline from the prior peak. If there are any problems with today's housing market, it is a shortage of homes for sale and the difficulty that many borrowers are having finding financing, due to tighter regulatory guidelines.


These two measures of housing prices show that prices rose between 7-12% last year, and are relatively unchanged for the past four years.


In real terms, the Case-Shiller measure of housing prices rose 5.5% last year, after falling over 40% from its early 2006 peak. This is how markets clear: as time passes, prices fall until the supply and demand for homes reaches a new equilibrium and prices stop falling. By all measures, there has been plenty of time and price adjustment for this market to clear. We therefore are most likely entering a new phase of the housing cycle, in which prices will tend to rise even as new supply comes on the market.


A different version of the Case-Shiller data, going back to 1987 but covering fewer markets, tells the same story. After a huge decline from the 2006 high, inflation-adjusted prices today are only 15% higher than they were in 1989, 23 years ago.


This chart of real median home prices goes back even further and tells the same story. From an historical perspective, inflation-adjusted home prices are only slightly higher today than they were many decades ago, yet interest rates are much lower. Homes have never been so affordable. As buyers become more confident that prices are not going to fall and are more likely to rise, demand for homes will continue to rise. Sellers, meanwhile, will be less anxious to sell as they see that prices are firming. The millions of homeowners who are still "underwater" will also become less anxious about their plight as prices rise. In short, the market has lots of room and time to recover. Housing is now a "sellers' market" in many areas of the country. 


As the chart above shows, housing prices are much more affordable today than they were in 1989, because real incomes are up and borrowing costs are down. 30-yr fixed rate mortgages were 8% in 1989, and they are less than 4% today.


There has been a significant decline in the number of vacant homes for sale. Banks may still be holding back lots of inventory, but what is coming on the market is selling. The vacancy rate today is not unusually high at all, from an historical perspective.



These charts make it clear that there is a shortage of homes for sale. The supply of homes for sale, relative to the current sales pace (which itself is very depressed) is about as low as it has ever been.


New home sales (today's big news release) were up over 15% from November to December, and they rose almost 30% last year. But they are still extremely depressed compared to the pace of the past two decades. With housing starts up over 60% in the past two years, new home sales are almost certain to post very strong gains this year.

A strong housing market is going to provide good support for the economy in the years to come.