Monday, December 14, 2009
Today marked a milestone of sorts: the S&P 500 hit a new closing high for the year, even as the dollar traded about 3% above its November lows. For almost all of the past year or so, there has been a strong inverse correlation between moves in the dollar and equities. Now we see that relationship possibly beginning to break down. If this continues, it could have some very significant consequences, although there is some fundamental disagreement about what those consequences might be.
To sort through the consequences of a new relationship between the dollar and equities, consider first that the "carry trade" is a popular theory for explaining the inverse correlation between the dollar and equities and other risk assets to date. According to this theory, a weaker dollar is a sign of people borrowing dollars and investing the proceeds in equities and other risky assets such as commodities, oil, gold, and other currencies. By keeping short-term interest rates close to zero, the Fed has provided tremendous encouragement to this trade, and this in turn is supposed to facilitate an economic recovery by pumping money into the system, reducing credit spreads, and boosting U.S. exports. However, it brings with it some very unpleasant inflation consequences, and it also means that the recovery is fragile, since it is built on a foundation of speculative activity rather than investment. Those who believe in this theory worry that a stronger dollar and/or a tighter Fed will shut down the carry trade, and thus expose the economy to a painful economic relapse.
I've explained the inverse correlation between the dollar and equities quite differently, keying on the demand for money. I've documented in a series of posts how changes in the value of the dollar since early 2008 have corresponded to changes in the demand for money (which is of course the flip side of money velocity). The dollar rose last year as money demand soared; this was reflected in a surge in the amount of dollar currency outstanding, a surge in the M1 and M2 measures of money supply; and a severe contraction in nominal GDP. Just the opposite has occurred since last March: money demand has declined, the dollar has weakened, the growth of dollar currency, M1 and M2 has dropped to near zero, and nominal GDP has picked up. In short, money that last year was hoarded was returned to circulation this year, thus boosting the level of economic activity. Declining money demand this year was thus symptomatic of a return of confidence and a portent of improving economic conditions in general; rising prices of equities and other risk assets were all simply the natural result of an improving economy.
It is also the case that there has never been a stable or enduring correlation between equities and the dollar. So if the correlation going forward becomes positive instead of negative there is no reason in principle to be concerned.
In the current situation, however, I think that a positive correlation between equities and the dollar would be a good indication that the economy was improving on its own merits, without help from money demand or the Fed. Since markets have been deeply distrustful of the economic improvement to date, and just as convinced that the Fed will have to keep interest rates at zero for a very long time, any signs that the economy is experiencing genuine growth directly contradicts the market's fundamental assumptions. We have seen hints of this already, in the form of declining unemployment claims and sharply reduced job losses, plus broad-based strength in commodity prices, and of course all the V-signs that I've been posting about for months. A stronger than expected economy would inevitably lead the market to demand more equity exposure, at the same time it would lead the Fed to tighten sooner than expected. Rising interest rates need not pose any great risk to the economy in my view; indeed, rising interest rates would be a very welcome indicator of economic health and vitality.
And of course, as a supply-sider I am a firm believer in the concept that a strong currency is always better than a weak currency. And since the dollar currently trades at historically low levels relative to most other major currencies, a stronger dollar would be doubly beneficial, since it would mark a badly-needed return of confidence (which would bring with it increased investment), as well as a lessening of inflationary pressures.
Posted by Scott Grannis at 3:27 PM