Currency valuation, in this case the relative value of the U.S. dollar, has implications across the economy and markets. Despite the importance of this metric, the topic of currency valuation can be a difficult one to navigate.
Most of the time when a market pundit or reporter refers to the “value of the dollar,” they are doing so in the context of an indicator called the U.S. Dollar Index. The U.S. Dollar Index is a computation of the relative value of the U.S. dollar versus a basket of other important world currencies. Fifty percent of this index value is based on the value of the dollar versus the euro. The “par” value of the U.S. Dollar Index is $100; index values over this value indicate an appreciation in the relative value of the dollar, and index values under $100 indicate the opposite. The U.S. Dollar Index can provide a decent view into the perception of U.S. government and Federal Reserve policy, but like all market indicators it is also subject to short term volatility and speculation, which makes it a less than perfect tool.
The relative value of the dollar against other currencies, however, is not the only relevant metric when assessing the consequences of economic policy. Perhaps the most important real word metric is the value of the dollar in relation to other items of intrinsic value (commodities), and the value of the dollar in relation to supply chain costs and consumer prices for goods and services, aka inflation. Once again, however, there are many factors that come into play regarding supply chain costs and consumer prices, so over the short term these measuring sticks can also be a bit “noisy.”
Currently, we find ourselves in a situation where the U.S. Dollar Index is now priced at the lowest level in seven years (source: MarketWatch), at the same time as consumer and producer prices as measured by the government’s CPI and PPI data are at the highest level since 2011 (source: NEBR). This correlation is to be expected, as both indicators are flip sides of the same coin, although the Dollar Index is a real time indicator and CPI is a lagging indicator showing price changes in the previous month or quarter.
Rather than get into the mechanics of this, to me the key is that this convergence of these multi-year highs and lows looks like a possible inflection point, and if these trends continue investors will need to be aware. Investors certainly have plenty to pay attention to as we crawl out of the COVID-19 crisis, and adding the U.S. Dollar Index to the list seems like a lot.
It will admittedly be easier to follow inflation as reported by the CPI, as after a long hiatus of taking a benign CPI for granted, at this point markets are no doubt going to be very focused on this indicator going forward. My concern is that CPI is a lagging indicator, and by the time we get a look at the official number, the markets will have anticipated the trend and already adjusted.
Instead, I think it is better to understand the policies likely behind these trends and take action as early as possible if they continue. Whereas in prior periods news of massive federal economic stimulus was met with approval by liquidity hungry investors, I won’t be surprised to see this trend reverse in the coming months.
If rhetoric coming out of the Biden administration continues to push various multi-trillion dollar “plans,” and the Federal Reserve continues to signal its intention to keep stimulating the economy with zero percent interest rates and expanding monetary base through bond buying, at some point I’m concerned markets will become afraid of policy makers losing control of both inflation and currency stability, harkening a period of extreme volatility.
Right now, most of the Democratic multi trillion-dollar spending rhetoric can be classified as negotiating tactics, and there is still slack in the labor market justifying the Fed's continued accommodative monetary policy, but headlines on the political side are bound to evolve, and hopefully Fed policy guidance will do the same.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stock investing includes risks, including fluctuating prices and loss of principal. Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at email@example.com. Securities offered through LPL Financial, member FINRA/SIPC.