Returns on assets

A reasonable person could ask why the currency market would not react more rapidly to very different money supply growth rates. After all, if you create more dollars, shouldn’t every one be worth less, all else held equal? The answer lies in anticipated returns. If the money supply is growing because of increased bank lending and other extensions of credit, the underlying economy should be stronger and assets denominated in that currency should have a greater return.

We can check this by comparing U.S. and European stock indices. Let’s compare the very broad Russell 3000 index to the Morgan Stanley Capital International Euro Index. The pattern has been clear and distinctive: The relative performance of the stock indices leads the movements in the currency and the periods of out performance coincide with the periods of more rapid money supply growth. As the respective central banks relax their policies and as the respective commercial banking systems create new credit, the expected returns on assets increase. This makes the easy-to-follow returns of broad stock market indices a good leading indicator for the DXY.