How does a dollar rally appear to the world?

One reason I believe the U.S. dollar rally could be epic is due to the international impact of a massive deflation. Changes in currency value drive investment because, ceteris paribus, it increases the value of everything in the country. During a currency appreciation, a hefty slice of the return for a foreign investor can be due to a change in currency valuation. This creates a feedback loop that leads to rising asset prices and rising currency as more money flows into a country, and it reverses very rapidly on the way out. Think Asian Crisis in 1997.

Speaking of the Asian Crisis, at that time there was a big U.S. dollar rally and that helped fuel the technology bubble. Here's Alan Greenspan on January 3, 1998:
Nonetheless, a drop in the prices of existing assets can feed back onto real economic activity, not only by changing incentives to consume and invest, but also by impairing the health of financial intermediaries--as we experienced in the early 1990s and many Asian countries are learning now. But historically, it has been very rapid asset price declines--in equity and real estate, especially--that have held the potential to be a virulently negative force in the economy. I emphasize rapid declines because, in most circumstances, slowly deflating asset prices probably can be absorbed without the marked economic disruptions that frequently accompany sharp corrections. The severe economic contraction of the early 1930s, and the associated persistent declines in product prices, could probably not have occurred apart from the steep asset price deflation that started in 1929.
In 1998 and into 2003, Greenspan was worried about deflation because he just witnessed it in Asia and saw an ever increasing U.S. dollar. While the deflation argument one hears from the bears is based in macro and microeconomics, in the late 1990s it was capital flows that were driving the discussion.

Bringing it back to today, look at the 6-month chart of the SPDR S&P 500 (SPY). It's basically flat for 2010.

Now look at how the SPY appears to a European investor whose home currency is the euro (using CurrencyShares Euro (FXE) for comparison:
The chart uses a price ratio and the price of SPY is currently 90% of FXE (as of June 18, FXE was $123.36 and SPY was $111.73). This is also the euro value of SPY, if one converts $111.73 into euros, it would be $90.19 at the current rate of 1.2388. Assuming the euro went to parity, SPY could still be worth $90.19 to a European if it fell to $90.19, a drop of 19% from these levels. Any smaller decline would appear as a gain to a European and may lead to increased purchasing of U.S. assets, thus leading to further U.S. asset relative outperformance. Also, consider U.S. Treasuries, which will go up in nominal U.S. dollar terms during a deflation. From about April 24 until iShares Barclays 20+ Year Treasury (TLT) peaked on June 7, an investor keeping score in euros would have seen this ETF rise 24%.

Therefore, it is very likely that another major bout of deflation will again result in a move into U.S. dollars, not just by euro holders, but by anyone holding currency that is rapidly depreciating versus the U.S. dollar. This isn't meant to be an argument for deflation, that will come about for other reasons. But for inflationists who cannot imagine how the U.S. dollar could rally or become a "safe haven" asset again, this shows that the reversal of capital flows alone can deliver a sustained U.S. dollar rally.

No comments:

Post a Comment