Fundmastery Blog

Kurt Brouwer October 5th, 2009

As you know, the dollar has been falling against the Euro and other currencies lately. But, it is sometimes hard to put that in an actual historic perspective. Also, it’s hard to understand why the dollar is falling. With this post, the goal is to give you answers on both questions — How far has the dollar fallen? And why is it falling? And, we also want to discuss what is likely to be ahead for the declining dollar.

Declining the dollar

Do you remember hearing that the Euro fell to historic lows versus the dollar in 2001? In fact, the Euro fell steadily versus the dollar for the first five years of its existence, beginning in January 1999. It did not get back to even until mid-November, 2003. At the low point for the Euro you could have bought one for 84 cents. Now, it takes a $1.46 to buy one Euro.

Here is a chart showing the fluctuations of the Euro versus the dollar since inception in 1999. This shows how many dollars it takes to buy one Euro. When the blue line is heading down, the dollar is getting stronger. When the line heads up, the dollar is getting weaker.

U.S. Dollar / Euro

Source: St. Louis Federal Reserve Bank

The gray bars in the charts indicates the relatively brief recession we experienced in 2001 and the longer recession we are experiencing now. You might notice that the 2001 recession coincided with the low point for the Euro (or conversely, the strongest point for the dollar during this time period). Why? The very strong dollar and the recession went hand in hand because the Federal Reserve raised interest rates beginning in 1999 and that led to the recession. Higher rates cause the dollar to strengthen, but they also inevitably slow down the economy. On the other hand, lower interest rates are positive for the economy, but often not for the dollar.

After the 2001 recession ended, our economy strengthened for years and the dollar fell, more or less continuously during that economic upturn. Coincidence? No. Here is a chart showing the Federal Funds target rate.

Federal Funds Rate

Source: St. Louis Federal Reserve Bank

As you can see from this chart, the Federal Reserve began raising interest rates (blue line going up) to slow down the technology bubble in 1999. By comparing this chart to the first one, you can see that when U.S. interest rates went up, the dollar rose versus the Euro. When the economy fell into recession in 2001 (the first area in gray), the Fed began slashing interest rates and the Euro finally began strengthening versus the dollar. The Fed began raising rates again in 2004 due to inflation concerns and the Euro stabilized versus the dollar until the Fed stopped raising rates in 2006. At that point, the Euro began climbing and the process accelerated when U.S interest rates were cut significantly in 2007 as the economy began to weaken.

Flight to the dollar during financial panic

During the financial panic at the end of 2008 and early in 2009, the dollar strengthened considerably.  This chart is the same data as in chart number one, the dollar versus the Euro, but for the period of 2008 and so far in 2009.  I also took off the recession bar.  Remember that the blue line going down means the dollar is strengthening versus the Euro, while the blue line going up means the dollar is weakening.

Source: St. Louis Federal Reserve Bank

The flight to the dollar during the panic began in the Summer of 2008 and ended in early 2009.  As the panic subsided, other considerations such as interest rates took hold again and the dollar again began to weaken against the Euro.  At the low point, it took nearly $1.60 to buy one Euro.  Then, during the depths of the financial panic, it took only $1.25 to buy one Euro, but now that same Euro would cost $1.46 or so.

What’s Next?

The big difficulty we face now is that the economy is weak and the Fed likes to have low interest rates to help the economy begin to grow again.  Low interest rates are helpful to overall economic activity, but, as you have seen, lower rates generally hurt the dollar.  If we wanted to help out the weak dollar, the response would ideally be to raise interest rates.  However, due to serious weakness in the economy, the Fed is hampered in its ability to respond to this situation and I believe it will opt to keep very low interest rates in order to promote economic growth.

You may hear various members of the Federal Reserve or politicians or pundits decrying the weak dollar.  However, for decades, our government’s philosophy during recessions has been to publicly espouse a strong dollar while, at the same time, cutting interest rates to strengthen the economy and give unemployment a boost.  This has traditionally been done despite the fact that lower interest rates generally lead to a weaker dollar.  I don’t see anything in the cards that appears to have changed that policy.   Therefore, I expect continued pressure on the dollar as the Fed seeks to get economic activity going again.

• Economy , Geopolitics , Investing , Money , debt , deficit
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Kurt Brouwer September 30th, 2009

Paul Volcker was the Federal Reserve chairman back in the early 1980s.  He had been appointed by President Jimmy Carter in 1979.  His task was to squelch inflation and that he did by sharply hiking short-term interest rates.  Unfortunately, the economy took a huge hit as a result of his inflation-fighting efforts, but he did kill off inflation for a generation.  That feat alone gives him enormous credibility in terms of our banking and monetary system.

Now, of course, Volcker is back in the news as an economic advisor to this administration.  However, they are apparently not taking his advice as this ABC News report suggests [emphasis added]:

White House adviser Paul Volcker today criticized the Obama administration’s sweeping financial regulatory reform proposals, specifically one that he warned could lead to future bailouts by designating certain firms as “too big to fail.”

In testimony prepared for a hearing Thursday morning before the House Financial Services committee, the former Federal Reserve chairman expressed doubts about the administration’s proposal to designate certain firms that pose a threat to financial stability, subject them to stricter supervision, and make them submit resolution plans in the event of failure.

“The clear implication of such designation whether officially acknowledged or not will be that such institutions, in whole or in part, will be sheltered by access to a Federal safety net in time of crisis; they will be broadly understood to be ‘too big to fail’,” Volcker said.

This designation, Volcker said, will only serve to encourage more risk-taking, thereby leading to even worse crises in the future.

“What all this amounts to is an unintended and unanticipated extension of the official ‘safety net,’ an arrangement designed decades ago to protect the stability of the commercial banking system,” Volcker stated. “The obvious danger is that with the passage of time, risk-taking will be encouraged and efforts at prudential restraint will be resisted…”

…The former Fed chief also expressed opposition to the administration’s proposal to remove responsibilities other than monetary policy from the central bank…

Chairman Volcker (a shorter version):

First, let’s make banking boring again.  No bank should be too big to fail.  And, second, don’t mess with the Federal Reserve.

What was it like back in the early 1980s?

To see what Chairman Volcker was up against, let’s head back to those days of yesteryear — the early 1980s — and compare some key indicators to the situation back then.  Here is a good chart showing key interest rates plus inflation and unemployment, then and now:

Source: Carpe Diem

I suspect you could win some bets with some of these statistics.  How many folks really remember that home mortgage rates hit 18% back then?  Or, that they never went below 12% from 1979 through 1985?

Double Digits in 1980-82: Inflation, Unemployment & Mortgage Rates

In the late 1970s and early 1980s we had sky-high inflation, unemployment and mortgages rates. At that time, Chairman Volcker, had to raise interest rates to unheard-of levels. These rate hikes led to a prolonged economic contraction that was the worst since the Great Depression of the 1930s. This description from Wikipedia gives a sense of how severe the reaction was [emphasis added]:

“…However, the change in policy contributed to the significant recession the U.S. economy experienced in the early 1980s, which included the highest unemployment levels since the Great Depression, and Volcker’s Fed also elicited the strongest political attacks and most wide-spread protests in the history of the Federal Reserve (unlike any protests experienced since 1922), due to the effects of the high interest rates on the construction and farming sectors, culminating in indebted farmers driving their tractors onto C Street and blockading the Eccles Building…”

The image of farmers blockading Washington D.C. with tractors is hard to imagine now, but those were tough times.  The reason Volcker raised interest rates so aggressively was that inflation went wild in the late 1970s. For example, inflation hit 11.3% in 1979, 13.5% in 1980 and 10.3% in 1981 before Volcker’s harsh medicine began to kick in and inflation moderated to 6.2% in 1982.

As inflation ratcheted higher, so did home mortgages rates. Thirty-year fixed rate mortgages went up to nearly 13% in November 1979 and did not fall under 12% again until November 1985. The peak rate for mortgages was 18.45% in October 1981. 18.45%!

But, even though high interest rates began knocking down inflation, soaring rates also led to sharply higher unemployment. The unemployment rate peaked at 10.8% in December 1982. However, it had been soaring for years and it remained at 8% or higher until January of 1984. Given all this, it is not surprising that investors and consumers were very negative in that time period 1980-82.

As you can see from the chart above, there is a huge disparity between interest rates, inflation and unemployment today versus the early 1980s.  It is true, that government statistics on inflation and unemployment have changed since then.  Nonetheless, interest rates and inflation were much higher back then.  Unemployment was probably about the same although some would argue it is higher now due to changes in the methodology of calculating unemployment.  

In that period, the Federal Reserve had to fight pervasive inflation and the only means available was to raise interest rates.  As a result of higher interest rates, bond yields soared and bond values plummeted.  Higher interest rates hurt the real estate market and values fell.  Higher rates also hurt the stock market.

Inflation is not a huge problem now as it was throughout the 1970s and early 1980s.  For example, inflation averaged nearly 8% per year for the entire decade of the 1970s.  And, it began accelerating into double digits for the period 1979-81.  Clearly, that was a huge threat.

Is deflation underway?

Today, we have two competing issues:  current deflationary trends and likely future inflation influences (see Pimco Warns of Deflation To Come).

Right now, the government is more concerned with deflation than inflation as this report from the Congressional Budget Office indicates.  The CBO made this statement in the summary section of its recent report on the President’s Budget [emphasis added]:

…For the next two years, CBO anticipates that economic output will average about 7 percent below its potential-the output that would be produced if the economy’s resources were fully employed. That shortfall is comparable with the one that occurred during the recession of 1981 and 1982 and will persist for significantly longer-making the current recession the most severe since World War II. In CBO’s forecast, the unemployment rate peaks at 9.4 percent in late 2009 and early 2010 and remains above 7.0 percent through the end of 2011. With a large and sustained output gap, inflation is expected to be very low during the next several years…

The CBO estimates that inflation will be very low for ‘the next several years’ due to the output gap mentioned in the quotation above. That is, if global GDP is 7% below potential then there should not be a lot of pressure on pricing until the output gap is closed.

Will Paul Volcker’s voice be heeded?

However, even though inflation is not a pressing problem today, there are plenty of serious concerns we have about the integrity of the banking system and many other factors. Paul Volcker’s wisdom and experience are badly needed now and I hope the administration heeds it.

Unfortunately, I’m afraid that — so far — his recommendations are not getting the hearing they deserve.

• Business , Economy , Investing , Money , inflation
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Kurt Brouwer September 28th, 2009

During this recession, Americans are paying down their mortgages, paying off car and truck loans and moving back to old fashioned thrift.  And, Yet, despite all the cutbacks on the part of Americans, the country’s debt load has gone up due primarily to government borrowing.  Yet, even with all the new government debt, the country’s headlong race into indebtedness has slowed considerably:

Source: New York Times

The rate of growth in new national debt, is down to 3.7%, which is low by historical standards.  This piece by Floyd Norris from the New York Times gives some detail [emphasis added]:

THE United States government is borrowing money like never before. The national debt rose by more than a third over a one-year period, far more than it ever did at any time since World War II.

…This week, the Federal Reserve published its quarterly report on debt levels in the economy. While Uncle Sam borrowed more, others borrowed less. The accompanying chart shows that total domestic debt — the amounts owed by individuals, governments and businesses — climbed just 3.7 percent from the second quarter of 2008 through the second quarter of this year. That is the smallest increase since the Fed started these calculations in the early 1950s.

Moreover, domestic debt declined in the second quarter, falling 0.3 percent to $50.8 trillion. The figures are not seasonally adjusted, making quarter-to-quarter comparisons risky, but it was the first such decline since the first quarter of 1954, when total debt was less than $500 billion.

…Until this recession, the idea that American individuals would ever cut their overall debt levels seemed as likely as an August snowfall in Miami. But that was before the bottom fell out of the housing market, something that Florida condo developers had considered to be equally unlikely.

Over the year, total household debt fell by 1.7 percent, and mortgage debt — the largest component of household debt — fell a bit more, at a 1.8 percent pace. This is the 10th recession since the Fed began collecting the numbers, but the first in which the amount of home mortgage debt fell. Some of that decline, of course, came from foreclosures that canceled debt and left lenders with big losses…

Without the huge slug of debt put on by the government, our overall indebtedness would be falling.  Some economists and pundits think government borrowing is the only thing between us and disaster.  That may or may not be, but in my opinion it is disaster deferred not disaster avoided.

Even though households are cutting back, the U.S. Treasury just reached a new — albeit dubious — record:

The U.S. Treasury issued a new record of $7 trillion in bonds for the fiscal year that will end next week:

U.S. issues $7 trillion debt, supply to stabilize  (Reuters, September 23, 2009, Burton Frierson)

The U.S. government will have issued $7 trillion in bonds by the time the current fiscal year ends next week, but it expects the debt deluge to stabilize by mid 2010, a Treasury official said on Wednesday.

…However, this expansion may take place in an environment where investors consider leaving the safe-haven Treasury market for riskier assets, and debt issuance is likely to level off mid next year, said Treasury Acting Assistant Secretary for Financial Markets Karthik Ramanathan.

“In fiscal year 2009, which ends next week, Treasury will have issued $7 trillion in gross issuance — that’s in a 12-month period,” Ramanathan told a financial markets conference in New York…

A trillion here and a trillion there.  After a while, it adds up.  Not all of these bonds were brand new.  In fact, most of the bonds issued replaced bonds that were maturing.  Nonetheless, the new debt issuance is huge.  Reuters continues:

“This issuance was necessary to meet nearly $1.7 trillion in net marketable borrowing needs, nearly $1 trillion more than what we raised last year,” he added.

That’s sizeable.  $1.7 trillion in net new borrowing.

Finally, the headline of this piece cracks me up.  ‘U.S. issues $7 trillion debt, supply to stabilize.’  Since the Treasury determines what the supply is, I guess that’s like saying, “We’re borrowing scads of money now, but we plan to borrow less in the future.”  OK, that’s nice, but we’ll believe it when we see it.

Ordinary Americans have proved they can cut back, but it remains to be seen what happens when the recession ends and the recovery begins.  The reverse is true of government borrowing.

• Business , Economy , Money , Personal Finance , debt , deficit , inflation
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Kurt Brouwer September 23rd, 2009

Home prices are way down, but an uptick may be underway.  However, commercial real estate — office buildings, malls, warehouses, hotels, theaters — is still heading south.

Let’s start with home prices.  This chart shows the decline in home prices as shown by the S&P / Case-Shiller home price data versus the owners’ equivalent rent line (OER), tracked by the Federal government.

Owners’ equivalent rent attempts to measure the market value of homes in terms of rental income.  Without going into the details, I believe OER constitutes a good benchmark for evaluating whether or not homes are overvalued, undervalued or fairly-priced.

As you can see, we are getting back to a reasonable valuation level for homes.  However, markets typically overshoot on the downside of fair valuation just as they often overshoot on the upside.  If that’s the case, more trouble is ahead.

Source: Calculated Risk 

According to this data, home prices peaked in early 2006 and have slid ever since, except for a modest uptick in prices recently.  We do not know whether or not the bottom has been reached, but we believe we are quite close.  However, even if a bottom has been reached, real estate activity – sales of existing homes, new construction, remodeling – will remain at low levels for some time to come.

Commercial Real Estate:  Commercial real estate has also fallen hard although the downturn started later than that of residential.  Unfortunately, the decline and fall of commercial property has been very quick indeed. This chart compares the decline in residential with that of commercial. The blue-gray bars denote periods of recession.  The blue is residential and the red line is commercial.

Source: Calculated Risk

As you can see, commercial real estate took longer to begin falling, but the downturn has been steeper.   Now, both real estate markets are off considerably from the highs.

With falling prices for homes, those who provided residential mortgages have been the big losers.  And, unfortunately, the government is the ultimate deep pocket when it comes to home mortgages through takeovers of Fannie Mae, Freddie Mac and the possible takeover of FHA.

With falling prices for commercial real estate, those mortgages are under extreme pressure also.  But, commercial mortgages are typically held by regional and local banks.  Those institutions are now struggling and we have seen a rash of bank failures as a result. In a way though, the Federal government is the ultimate guarantor for banks too through FDIC guarantees.

For more on bank loans, see Bank Problem Loans Keep Growing.

• Business , Economy , Money , Personal Finance , debt , real estate
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Kurt Brouwer September 21st, 2009

Source: Bespoke Investment Group

I like this chart because it shows the growth in our net worth over a long period.  Net worth grew along with the equity market and when stocks began to falter in 2000, net worth kept going because home prices boomed.  When stocks fell again in 2008, real estate was also tumbling and net worth fell with it.  This chart illustrates how closely tied we are to the world of investments.

This piece from MarketWatch spells out the turnaround after a steady string of declines for our collective net worth [emphasis added]:

Household net worth rises for first time in two years (MarketWatch, September 17, 2009, Rex Nutting)

American households were $2 trillion richer on June 30 than they were three months earlier, the first time in two years that household net worth has increased, the Federal Reserve reported Thursday in its quarterly flow of funds report.

Household wealth rose in the second quarter at a 17% annual rate, or $2 trillion, to $53.1 trillion after falling at a 13% rate in the first quarter, the Fed said. It was the first time since the second quarter of 2007 that wealth had increased. Net worth is down $12.2 trillion from the peak in 2007, an indication of how much the collapse in stock prices and home prices have hurt. Read the full report.

…The rally on Wall Street was the main reason for the increase in household wealth, but rising home prices contributed as well. Wealth in corporate equities rose by $1.04 trillion, while real estate wealth rose by $139 billion. Assets held in mutual funds, life insurance and pension funds rose by $1.06 trillion…

It has been a long, hard slog for investors in stocks and in real estate.  No doubt there will be more trials ahead, but this is nice news.

• Investing , Money , Mutual Funds , Personal Finance , real estate
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