Returning to the macro

This quick tour of dollar impacts may seem to fall into the “everything you know is wrong” category, but this is not quite the case. Both the economy and financial markets are highly complex, dynamic, and chaotic systems with multiple feedback loops and asymmetric relationships. Therefore, it is important to add the “all things held equal” caveat. The effects posited may exist on a standalone basis — what mathematicians call a “partial derivative effect” — but are overwhelmed in a complete system.

Think of it as adding a drop of yellow paint into a can of blue paint. You learned in your childhood art class that this is supposed to produce green, but the single drop will be overwhelmed. The resulting mix is infinitesimally greener; you simply cannot discern it.

But if we isolate relationships that should work, we often find they are perfectly valid. Let’s look at a weaker dollar raising import prices in the U.S., using the measure of import prices minus petroleum imports. (Because petroleum is priced in dollars worldwide and is notably non-sensitive to currency fluctuations, it should be excluded from a price index.) The government only began tabulating this index in 1988.

The expected relationship exists in an asymmetric form. Import prices fell during the 1995 – 2001 bull market in the DXY in a quick, direct, and nearly linear response to the rising dollar.

The opposite is not true: During the 1988-1992 stable dollar period and the dollar bear market of 2002 - 2004, import prices rose only well after the dollar fell.

This is evidence of competitive behavior by exporters. If they increased prices immediately in response to the weaker dollar, they would risk losing market share to fellow exporters and domestic producers.

They respond by reducing margins to maintain market share; this is one reason why the stock markets of weakening-currency countries have tended to outperform their strong-currency brethren over the past decade.

However, a strong dollar provides exporters to the U.S. with an immediate reward. They can cut their prices and still receive full purchasing power in return for their exports. This explains the observed asymmetry.

Finally, these microeconomic responses to changes in the dollar explain why currency manipulation tends to be such a losing strategy for those who engage in it. It maps the year-over-year changes in the U.S.’s index of leading economic indicators against the DXY over the past 35 years. The U.S. twice engaged in deliberate and overt dollar weakness policies, during the mid-80s and 2002 - 2004. Did the leading economic indicators respond as intended either time? Hardly. All parties adjusted their prices and cost structures and adapted to the manipulation. Will this prevent further currency manipulation bouts? Not a chance.