Monday, December 14, 2009

Dollar relationship to financial assets

You may have puzzled over the relationship of the US$ to the stock, commodity and bond markets. The relationship has been very difficult for me to rationalize. If I were to briefly describe my understanding in simple terms, here is what I would say. The dollar value is a reflection of the sentiment of other governments, with different currencies, toward the US economy in relation to their currency. In other words, if in the eyes of a foreign investor, there is more risk for investing in their local currency and markets than for the same investing in US markets, they will buy dollar based assets even with a less valuable currency, increasing their cost. Now, as other currencies around the world deal with the financial crisis the way they need to, observers evaluate the result of their action and determine the risk it creates on investments and the stability of their currency. The result is sometimes a move to safe investments, sometimes the addition of risk investments. Since the US$ is still viewed a safe currency, the move to safety stimulates an upward change in the dollar while the move to risk does the opposite, stimulates a downward change. Some would describe the upward move as strengthening and the downward move as weakening. These adjectives carry connotations that are misleading. The weakening of the dollar is not necessarily a sign of a
crumbling economy. More often it is a sign of the mood for risk assets or safe assets. So that is a how I view the relationship of the dollar with other currencies. What is missing still, for me, is a way to describe what the markets watch to lead them to, or away, from the dollar. I'm on the trail of where the cash is coming from that is in support the markets. I have been in belief of a fun conspiracy story that says the Treasury and the Fed have proxies doing their bidding in the markets. While this may have some credibility, I am feeling more inclined to look at the idea that our markets may be getting enormous support from foreign investors who may prefer the perceived safety and stability of US markets. If this is where the money is coming from, that may say quite a lot about what condition they believe their markets are in. This is, bad!

Let me describe the market results we observed on 12/8/2009, based on dollar index moves. The dollar index rose 1/2 percent to 76.24. The Dow was down 1% at 10,285 and gold fell back $30 to $1,128, or 2.6%. From the results on this day, we can see how influential moves in the dollar are. A 1/2 percent move in the dollar index has not been a typical outcome, but nothing stay's the same. (And now, a different day, a different outcome. Today is 12/15/2009 and here is a recap like the one posted for 12/8: The dollar index rose 0.7 percent to 76.94, gold was little changed at $1,125. The Dow was down .47% to 10,452.)

Understanding these relationships is essential since the financial crisis seems to have become focused on currencies as a result of the unrestrained quantitative easing (money printing) being practiced around the world. Scanner

Here is a link to an essay published by The Chicago Fed, that discusses the question in more depth.