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VOL. 129 | NO. 171 | Wednesday, September 3, 2014

David Waddell

The Dollar Strikes Back

By David S. Waddell

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Movements between the dollar, euro, and yen profoundly impact global flows of goods and capital. Given recent language and policy shifts from the U.S. Federal Reserve (FED), the European Central Bank (ECB) and the Bank of Japan (BOJ), let’s re-examine global currency trends.

Japanese yen: As a powerful export economy since the 1970s, Japan consistently ran trade surpluses until 2011. After the Fukushima disaster, Japan became much more reliant on energy imports, and surpluses became deficits.

With a persistently sluggish domestic economy, the reversal in Japan’s trade economy lowered already low growth and inflation expectations. In response, Japan adopted the world’s most aggressive monetary policy designed specifically to weaken the yen, stimulate exports and promote debt eroding inflation.

Initially, this policy weakened the yen significantly, boosting Japanese asset prices, inflation and economic growth. However, progress has stalled out recently, inspiring calls for the BOJ to do even more. With Japan’s national economic strategy predicated on weakening its currency, expect the yen to weaken further.

The Euro: The ECB has only one mandate: price stability. Unfortunately, the 17 members of the euro are linked by a common currency, but not common governance or fiscal policy. Germany and Greece operate very differently, as we have learned. Without the ability to break away and devalue to rebuild their economies, the peripheral European nations have voluntarily deflated wages, prices and asset values.

This painful restructuring has become an undertow in the Eurozone. As such, inflation in the Eurozone has now reached a five-year low at 0.3 percent, well below the 2 percent desired by the ECB. Outright deflation in the Eurozone clearly violates the principle of price stability. To avoid deflation, the ECB must get much more aggressive, suggesting weakness for the euro.

The U.S. dollar: Currencies cannot all fall simultaneously! As relative instruments, someone’s loss must be someone’s gain. The dynamism of the U.S. economy has enabled the economic recovery in the U.S. to outpace Europe and Japan considerably. Expectations of further reductions in unemployment, gathering wage momentum and increasing consumer sentiment has shifted the monetary policy discussion from stimulus to restraint. In the global hunt for yield, higher rates in the U.S. will attract higher capital flows and more dollar demand. With dollar supply stabilizing, more demand means more value per dollar.

Since the end of 2012, the dollar has appreciated 40 percent against the yen as designed by the BOJ. Since May, the dollar has rapidly appreciated 6 percent against the euro in anticipation of ECB efforts to inflate. Overall, the U.S. dollar index has appreciated 2.3 percent on the year and 15 percent since mid-2011. Predictably, gold has lost considerable luster over the same time period.

Bottom line: The relative strength of the U.S. economy has quietly led to relative strength in the U.S. dollar. With the BOJ and ECB on the verge of additional easing, restraint by the Fed makes the U.S. dollar more attractive. Wider recognition of the dollar’s ascendance should increase global demand for dollar denominated assets, adding further support beneath these record highs.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.

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