John Bowden Connally Jr was a man of mixed fortune. At 12.30pm on 22 November 1963, Texas governor Connally was sitting in the front seat of the presidential Lincoln Continental convertible when John F. Kennedy was assassinated. Connally was seriously wounded but lived. He was a Democrat and later backed Hubert Humphrey over Richard Nixon in the 1968 presidential election, yet the victorious Nixon, not previously known for his magnanimity, appointed him treasury secretary in February 1971. This proved to be a poisoned chalice.
On 15 August, in the face of rising inflation and Vietnam War-related deficits he was forced to remove the dollar from the gold standard, thereby bringing down the entire postwar international economic system around him. His was the most eventful term of any postwar treasury secretary.
It was also one of the shortest. He resigned in June 1972. But not before he told a group of European finance ministers, in his down-to-earth Texan way, one of the most famous things ever said by a US treasury secretary. The dollar “is our currency, but your problem”.
What Connally was saying lay somewhere between the US didn’t care about the dollar, and it was going to do nothing about dollar weakness. Since secretary Connally uttered these words 45 years ago, benign neglect has characterized US exchange rate policy. The level of the dollar seldom features in the speeches and press conferences of modern US treasury or Federal Reserve officials. Even when it is mentioned in passing today, there is no hint of desired levels, target ranges or reference points.
There had been a flirtation with target zones between the 1985 Plaza Accord to stop the dollar rising and the 1987 Louvre Accord to stop the dollar falling. Those accords elicited mixed emotions about grand currency arrangements.
Today, Fed watchers pore over the entrails of the quarterly gross domestic product release, the monthly non-farm payrolls or weekly jobless claims and invoke Connally whenever anyone mentions the dollar.
And yet I have found it quite profitable to predict the balance of dovish to hawkish comments on US interest rates by Fed officials and thereby short-term shifts in bonds and stocks, by watching the dollar. Whenever the dollar index is at the lower end of its recent range, as in early May, mid-June, and mid-August, the balance of comments turn more hawkish, the dollar bounces, yields rise and the stock market runs into headwinds.
It is important to look at the dollar index rather than the more frequently quoted exchange rates against the euro, sterling, yuan or rupee. Following Britain’s vote to leave the European Union, the sterling has slumped to a 31-year low against the dollar at close to $1.30 and the euro has slipped to a low of $1.12. The dollar appears supreme.
However, these moves exaggerate the dollar’s real strength. Against a basket of currencies, the dollar has been in a narrow 5% range since the beginning of this year. Against the rupee, for instance, the dollar is 3% lower than where it was back in late February.
The dollar index is an exchange quoted index which measures the performance of the dollar against a basket of currencies based on the importance of those currencies in global currency transactions. The index began the year at 98.6 and then followed a jagged path down to 92.6 in early May before rising in serrated fashion.
We generally see “verbal tightening”—talk of higher interest rates to come—whenever the dollar is weak and falling through 94.0 on the index, and verbal easing whenever it is strong and reaching for 98.
The dollar is currently close to the middle of its recent range at 95.50 and so this would suggest that official comments will now come across as being more neutral than before.
This should push down market volatility and financial markets are likely to be range-bound for a bit. It is a time for relative value and stock bets rather than market directional ones.
I don’t believe that the Federal Reserve is shadowing the dollar. Over the medium term, exchange rates—especially when policymakers do not fiddle with them—are a good barometer of how tight or loose monetary policy is.
The stance of monetary policy is not just about the level of interest rates, but the competition for funds. When the competition is hot, the dollar will be strong and when conditions are loose the dollar will be weak.
The Fed appears to be acting against the wind, easing policy when monetary conditions are tight and tightening policy when conditions are loose. It is probably a sign of their deep uncertainty as to where the economy is going next.
In case all this sounds too simple, it is useful to observe that at any one time, financial markets are driven by simple relationships. The royal challenge is to know when the old simple relationship gives way to a new one.
The breakdown of the observed connection between a range-bound dollar and the dovish/hawkish balance of policy comments will come some day. When it does, it will be an important indicator of the long-awaited switch from an uncertain, dovish Fed to a more confident, hawkish one. This will prove a very heavy challenge to current market valuations.
Markets are seriously over-valued on every measure that does not take into account that cash is offering zero to negative interest rates. When playing the dollar’s range no longer works, run out of the kitchen.
Amid all the chatter about negative interest rates and secular stagnation, the prospect of a normalization of interest rates may seem like a long way away. But the recent jump in US personal incomes and the US budget deficit may bring greater balance to current rate expectations in the US. Keep a watchful eye on the dollar.
Avinash Persaud is non-executive chairman of Elara Capital Plc and emeritus professor of Gresham College.
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