The Too-Fast Dollar Drop

"Rapid and Disorderly" Rule is Guidepost

The iPod indicator

I have for many years said that the markets will tend to shake off declines in the value of the dollar except when they are "rapid and disorderly." With the dollar having fallen five of the past six years, this has been the best approach in terms of forming an expectation of a response in the financial markets to the dollar's decline. Indeed, those who have bet against the U.S. economy and its financial markets on the basis of a falling dollar have repeatedly bet wrong.

Today, however, the dollar is down almost 1%, a magnitude that in other episodes qualified as "rapid and disorderly," particularly when such declines followed declines of a similar magnitude. Hence, equity prices might fall so long as the dollar is falling at a fast pace. The moment the dollar's drop stops or slows, equity prices will probably rally, all else equal, as it has in past episodes, with many focusing on the positive aspects of the dollar's fall. In particular, it is notable that U.S. exports over the past year ran $500 billion more than five years ago, partly because of the weaker dollar.

It is important to keep the dollar's drop in perspective. On a trade-weighted basis, Federal Reserve data show that the dollar has fallen by about 7% over the past three years, a large decline but not significant when you consider that this means there were only a few percentage point declines on average per year over the past three years. Hence, the dollar's drop has been rapid and disorderly only on occasion, occasions that caused difficulties for equities and other risk assets only for short periods of time.

The dollar's drop relates in part to the Fed's larger-than-expected interest rate cut, which has spurred an almost too-obvious round of comparisons between interest rates here and abroad. A more worrisome angle is the idea of the loss of Fed credibility, an issue that Ben Bernanke is likely to resolve and in which Bernanke has already dealt his first salvo by reemphasizing inflation recently. Bernanke nevertheless has much work to do given the many questions raised internationally by the recent rate cut.

Whatever the motivation now to sell dollars, there is now a piling in on a trade getting a bit tired in the sense that the forces that have driven lower to fall at a faster pace this year than last year are no longer inexorably moving in one direction, although there are question marks to . For example, U.S. economic growth has been quite weak for nearly 18 months, a trend that the Fed's interest rate cuts are meant to cure. Moreover, while the global economy is strong, it is not without imperfection in the sense that there are issues abroad that could motivate investors to buy dollars. For example, if China chooses to take actions (probably around the Olympics) to reduce inflation, its slower growth will reduce demand for commodities and hurt the emerging markets, likely spurring dollar buying. In England, its famed central bank has arguably erred in its policymaking recently, remaining stubbornly tight when the markets clamored for liquidity, an unsettling situation that favors dollar assets. In Europe, the sense of economic reform is likely to find limits, at some point, given many entrenched aspects of the economies there, particularly with respect to government taxation, regulation, and trade policies.

Also providing a safety net against a dollar rout is the increasing influence of an old theory: purchasing power parity. The prices of identical goods, such as an iPod, sold in the U.S. and abroad, are diverging. A 16 GB iPpod Touch costs $399 in the U.S. In England, the cost is 255 pounds, which amounts to $535 after the conversion from dollars to pounds.

I have called for the dollar to gain only once in recent years, in 2005 when it advanced on signs of stronger-than-expected economic growth in the U.S. I see forces now that might be shaping the next interruption in the dollar's fall, most of which are only in their nascent stages, hence putting off the call for now, but these forces could move swiftly in the dollar's favor. Key will be the U.S. labor market and the ability to absorb excess housing supply. This is obviously a major unknown at the moment.