A Stronger U.S. Dollar in 2010?

The sickly U.S. dollar will find renewed health and vigor, beginning in 2010, according to an analysis published by three economists.  Christian Broda, Professor at the University of Chicago, and Head of International Research at Barclays Capital, Piero Ghezzi, Managing Director, Head of Economics and Emerging Markets Research, Barclays Capital, and Eduardo Levy-Yeyati, Director, Head of Emerging Markets Strategy, Barclays Capital have jointly authored research showing that the ongoing decline in the value of the U.S. dollar is likely to be broken next year. 

This year stock markets around the world, including the Dow Jones Industrial Average, Nasdaq and S&P 500, have rallied as the value of the U.S. dollar has declined against other currencies.  Most the dollar’s fall can be explained by the loose Federal Reserve monetary policy, which includes interest rates of near zero and multiple government-sponsored programs to generate liquidity in credit markets (i.e. printing money to keep credit flowing).  But as Bespoke Investment Group LLC points out, a falling dollar and a rising stock market is an anomaly in history.  The following is snippet of Bespoke’s analysis: 

The average return of the S&P 500 during the five dollar bull markets has been a gain of 59.17%. In dollar bear markets, the average return for stocks is considerably lower. Even if we include the current dollar decline, which has yet to meet the -20% threshold for a bear market, the average return of the S&P 500 during dollar bear markets has been a gain of only 23.65%. It wasn’t until the last bull and bear market in the dollar that the S&P 500′s returns shifted. In the prior four dollar bull/bear cycles, the S&P 500 always performed either inline or worse during the dollar bear market than it did in the preceding bull.

When the credit crisis hit with full force in the fall of 2008, the US dollar rose sharply, while US interest rates fell sharply.  The three economists had noted in previous research “the puzzling response of the dollar and US rates during the panic of the fourth quarter of 2008—stronger dollar and lower rates—would be temporary and that the return of risk appetite and structural aspects of the new global balance—smaller gross capital flows and the savings drain resulting from global fiscal policies—would steepen rates and weaken the dollar.” 

The authors believe that both U.S. monetary and fiscal policy will join forces to push long-term rates higher when quantitative easing ends. The end of quantitative easing in 2010 and the start of the tightening cycle in the U.S.—both supportive forces for the dollar—should also compensate dollar-negative fiscal considerations. Thus, contrary to the popular view of a continuously weaker dollar, the phasing out of quantitative easing implies that the dollar may strengthen in 2010 relative to other currencies. 

If that is true, many stock market analysts currently believe that a stronger dollar, especially one brought on by central bank exit strategies, would destroy the recent market rally.  However, viewing the market from Bespoke’s perspective, such a change would likely be positive for the market in the long run.  One should consider too that the Federal Reserve has stated that it will keep rates near zero for as long as necessary to get the economy going again.  If the Fed lifts rates and exits other monetary programs, this would be a strong signal that the economy can stand, walk and perhaps run on its own two feet. 

Please click on the following link to view the economists’ research at Voxeu.com:  The new global balance – Part II: Higher rates rather than weaker dollar in 2010