Saturday, September 22, 2007

The Canadian dollar is now trading 1 for 1 vs. the US dollar for the first time since the mid-1970s. This is a very sad milestone. The charts below make some interesting points. Based on my estimates of purchasing power parity, the loonie is now as strong against the buck as it’s ever been. Conversely, the buck has never been weaker against the loonie. So is the loonie just terrifically strong or is the dollar hopelessly weak? I’m inclined for the latter explanation, and I say that because of the second chart, which shows that the loonie’s strength has gone hand in hand with the strength of commodity prices. And commodity prices are up a whole lot more in US dollar terms than they are in any other major currency’s terms. Indeed, you could make the case that commodity strength (and loonie strength, by extension) is largely a function of dollar weakness. Commodity prices haven’t changed much in loonie terms over the past 10 years, whereas they are up about 45% in dollar terms.

At what point are the guardians of the dollar’s value at the Fed and the Treasury going to sit up and take notice of the dollar’s slow and painful demise? Benign neglect of the dollar’s sinking value can’t be a permanent fixture of our monetary policy without some inflationary consequences down the road.

The list of weak dollar fundamentals is impressive:

Political: no one cares, not even the Fed or Treasury. Indeed, most politicians are actively pushing for a weaker dollar, particularly against China. A Democrat seems likely to win the presidency, according to the futures markets, and the Democratic Party seems absolutely committed to higher taxes in order to redistribute income and fund a nationalized health care scheme. As one who believes in supply-side logic, higher taxes are not only unnecessary (the budge deficit is so small as to be almost irrelevant) but dangerous to the economy’s health. And the prospect of higher taxes certainly does not add to the appeal of investing in the U.S.

Monetary: the Fed was very easy for a long time a few years ago, and they have just recently opted for backstopping the economy at the expense of a little more inflation. The Fed hasn’t said word one about the dollar’s value being a source of concern for a very long time.

Growth: the US economy is among the weakest of the G15, and is clearly overshadowed by the booming emerging market and Asian economies.

Global: there are quite a few countries who are feeling pretty bad about having pegged their currency to the dollar: Chile, China, and Saudi Arabia, to name a few, and there are rumblings about unpegging from the dollar in certain quarters. China’s inflation rate is going up as its currency sinks with the dollar. There are central banks who have amassed significant dollar reserves who are feeling sick to their stomachs.

Lots of people would like to believe this can’t go on forever, and the bold are thinking that the dollar might be one of the cheapest assets in the world today. But what is missing is a reason to believe that the dollar can reverse this ugly tide.

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