Blog : The Dollar Is Pulling No Punches

by Ed Zwirn on October 2nd, 2014

The price of crude oil is below $90 a barrel. Core inflation in the U.S. is almost non-existent already, and the pronounced rally the dollar has seen over the past five months promises to keep prices low not only for oil and other commodities, but for a wide range of imports, particularly from Europe.

Looking at it one way, cheap gas and a strong dollar would seem to put the U.S. in a sweet spot economically. Americans enjoy an increase in disposable income for every penny less paid at the pump, and stable prices might mean that they get to pocket some of this increase. Companies stand to benefit from a reduction in dollar-denominated costs, dovetailing with an increase in the disposable incomes of their potential customers.

But here's another way to look at it: The dollar has gained 8.2% against the euro so far this year, 9.9% since hitting a trough on May 9. At the same time, stocks have performed poorly. The Dow Jones Industrial Average, in the wake of recent market reversals, is up 1.4% on the year. The NASDAQ Composite has done better, being ahead 6.1% YTD. Penny stocks have fared badly as a group in 2014, with the small-cap Russell 2000 index off 5.8% since Dec. 31, 2013.

In other words, you could have done much better by holding onto your money than investing it in stocks this year. This perverse incentive cannot have escaped the notice of corporate treasurers, as evidenced by their increasing tendency to horde cash balances. And, it being a tough world out there, volatility is increasing the nest-egg instinct as frightened investors seek safe havens.

And there is every reason to believe that the dollar rally will continue. By one of those instances of superb timing, the European Central Bank announced Thursday that it would be buying assets under its own version of quantitative easing for at least the next two years. In making this announcement, at the same time keeping target interest rates at a record low, ECB President Mario Draghi reiterated earlier guidance that the asset purchases would be targeted toward steering the central bank's balance sheet back to levels seen at the start of 2012, an increase of 1 trillion euros ($1.3 trillion) in assets.

The ECB will start buying covered bonds this month and asset-backed securities by the end of the year. Assuming this euro-QE program lasts exactly two years, making the ECB's balance sheet target would entail a net asset purchase of about $54 billion each month. This month, U.S. Federal Reserve Bank is widely expected to finish tapering off its QE2 program, which had been pumping $85 billion monthly into the economy up until late last year.

As I've pointed out in this investment blog, other recent ECB actions have played a large part in precipitating this dollar rally. Since June, the European bank has not only lowered rates twice, it has also announced a range of measures designed to flush cash into circulation, notably by charging interest on deposits held by it (so-called "negative" rates).

It is easy to understand why the Europeans are taking this tack. Inflation in the eurozone is at its lowest level in five years. Economic growth in the zone came to a halt in Q2, and even Germany, the bloc's most powerful economy, has seen manufacturing shrink. Devaluing the euro offers the quickest possible antidote to this dilemma by making eurozone exports cheaper.

At the same time, Europe's trading partners are painfully aware that the eurozone is already running a current accounts surplus of 3% of its output. The ECB's loosening, coinciding with the Fed's tightening (or at least holding its ground), will only exacerbate this trade imbalance at the same time as lowering the value of the euro. The U.S. will see export-dependent industries suffer as their products become more expensive abroad, and it remains an open question how long Washington's patience with this state of affairs will hold up.

How Janet Yellen and Mario Draghi manage to work this one out without derailing either of their respective economies ought to prove interesting. But the possible downside of failure far exceeds the impact of a stock market correction, bad as that is. Hardly a day goes by that governments are not announcing new sanctions these days. Russia and the "West" have basically evolved into mutually antagonistic trading blocs. Iran and many other countries (however odious) are still cut off from trade, and one can cite many other instances in which world trade is being hampered or prevented by sanctions, retaliatory measures, disease and war. If a split between the E.U. and the U.S. emerges, this could well go down as the year in which the high tide of globalization began to ebb.