If you just focused on the headlines in news reports you would be excused if you thought the dollar has had massive moves in the first four months of 2018.
Earlier in the year, the markets were fretting about the weakness in the dollar, and now it seems that pretty soon we will be fretting about the strength of the dollar.
Actually, dollar strength could not be further from the truth. As the aggregate dollar index shows, there has been some increase in volatility but no significant change in the underlying trend. And of course, the year-to-date change in the dollar is actually 0.3%. Exhibit 1
Contrast the move so far this year with the dollar’s move lower a couple of years back and it becomes quite clear that both the downside move in the dollar in the early part of 2018, and its subsequent move up, have been quite modest. Further, the dollar’s move is much less significant in light of the moves we have seen in equities and U.S. bond yields.
So, yes, keep watching the dollar, but don’t get too worked up about the small moves.
Dollar True Weathervane of Economic Cycle
Having said that, I still believe the dollar ̶ far more than the 10-year U.S. Treasury or the S&P 500 Index ̶ is the true weathervane for the current economic regime. And the dollar’s significance has moved up a few notches with the passing of the deficit-financed federal tax cuts and budget deal in an environment where the U.S. savings rate has dropped to 3.1% after averaging closer to 6% during the current expansion.
So, what precisely are we looking for in this dollar watching?
I believe in a period when the U.S. is going to have large fiscal deficits and low domestic savings, it is best for the cycle if those fiscal deficits are financed by capital imports. For that to be the case, again, the best outcome is for the dollar to remain largely range bound. That would imply decent U.S. growth but with a lot of the impact of that growth leaking overseas.
I believe the dollar’s current moves are largely range bound. However, if the dollar does not remain range bound, the worst outcome for the U.S. economic cycle would be a meaningfully weaker dollar. It would imply that foreign investors are not funding the U.S. deficit, which would then have to be funded internally. That, in turn, would imply that the U.S. savings rate would have to go up, and the easiest way for that to happen in the current context would be for U.S. wages to rise. In that case, inflation will accelerate and interest rates will climb, forcing the U.S. Federal Reserve’s hand and killing the cycle.
On the other hand, if the dollar strengthens a lot, it is not an ideal outcome, either, but it is definitely not as bad as a weak dollar.
A strong dollar implies significant increases in foreign flows into the U.S. If those flows are accompanied by weakening international growth and inflation, that will create both a political and economic problem for the U.S. economy – trade frictions will increase and the U.S. once again will be the recipient of international deflationary pressures. In other words, I believe we would see a repeat of 2015-2016 in the U.S.
However, if a strong dollar is accompanied by strong international growth and stable inflation, it may prove far less catastrophic, both politically and economically. U.S. growth will be decent and so would growth in emerging markets. Growth in Europe and Japan might be less robust, but still decent. The best indicator of that scenario playing out would be stability or an upward trend in oil and commodity prices.
The bottom line is that both U.S. and global growth are still quite good and, as a result, I remain quite sanguine about the current market and economic regimes. The dollar move so far this year has been quite modest, both on the downside earlier and the upside more recently.
That being said, in the current environment, I worry far more about the downward move in the dollar than the upward move. That is especially true if the upward move is accompanied by strength in oil and commodity prices. Watch the dollar but don’t fret too much. Not yet, anyway.