The Dollar's Evolving Outlook

The foreign exchange market sees an average daily turnover of around something on the magnitude of $6.6 trillion a day. In a week, the turnover is sufficient to more than cover world trade for a year. It is the largest of the capital markets. Trends in the currency market can last for years. 

A little more than a year ago, we concluded that the dollar's third significant rally since the end of Bretton Woods was over and that a cyclical dollar decline was at hand. Yet the dollar's price is only known relative to another currency, and there are more than 100, or a basket of currencies. What exactly does it mean that the dollar's "third significant rally" was over?

(Click on image to enlarge)

Here is a chart of the dollar that is the best measure of its economic impact. It a broad trade-weighted measure the is adjusted for inflation. The real broad trade-weighted dollar index is the way the Federal Reserve thinks about the dollar as well. The chart here from Bloomberg goes back to the 1970s. Nixon broke the last link between gold and the dollar on August 15, 1971. There is an attempt to put Bretton Woods back together, but it fails. The first big dollar rally we associate with Reagan, though in fairness, it began before he took office. Nevertheless, the Reagan dollar rally was a function of the policy mix. There was a tight monetary policy from the Volcker Fed as double-digit inflation is squashed with punishing interest rates despite high unemployment. Meanwhile, Reagan pushed on the fiscal accelerator. Taxes were cut, and defense and social spending increased. Such a policy mix, loose fiscal and tight monetary policy, appears to be the most favorable for a currency.

The dollar enjoyed its first post-Bretton Woods rally, but it proved too much. The marked appreciation of the greenback led to a widening trade deficit and protectionism at home. The strength of the dollar was kindling inflation pressures in Europe and Japan. Officials from the G5 met at the Plaza Hotel in New York and agreed to drive the dollar lower through joint intervention. The dollar went through about a ten-year bear market. 

Starting in the spring of 1995, the dollar's second significant dollar rally began. The Clinton dollar rally was a function of the new technology rally, the age of the PC. Americans kept their savings at home, and foreign investors could not get enough of the new economy stocks. Another change took place, which was also important. Robert Rubin replaced Lloyd Bentsen at the head of the Treasury Department. He needed to distinguish himself from his predecessor and announced a "strong dollar policy." This shift was important even though it was disputed nearly from the start, and the policy lasted for nearly two decades through Democratic and Republican administrations.

The "strong dollar policy" was never about the exchange rate per se. It was a pledge to investors and creditors that the US would not seek a weaker dollar to secure trade advantage or reduce its debt burden. Until then, the US had used the dollar's exchange rate as a weapon to win concessions from Europe and/or Japan. Rubin broke from that tradition. It took several years, but the G7 and then the G20 embraced Rubin's innovation. It was similar to an arms control agreement. We could pursue beggar-thy-neighbor competitive devaluations, but let's agree to refrain. Let the exchange rate be determined by market forces while avoiding excessive volatility. 

Meanwhile, the euro was launched on January 1, 1999, and proceeded to slump. It was launched near $1.1760 and proceeded to rally the following day to around $1.19, but that was it. It would not see that level again until the middle of 2003. The euro proceeded to fall through $0.8500.Two developments took place that served to cap the dollar. The tech bubble popped, and the Europeans organized coordinated intervention to stop the euro from falling in October 2000, which entailed selling dollars. 

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Read more by Marc on his site Marc to Market.

Disclaimer: Opinions expressed are solely of the author’s, based on current ...

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