When using the US dollar index to guide you…

On March 2, 2013 by Phil Champagne

By Phil Champagne, Managing Partner, Wren Investment Group

The US dollar index is among one of the key tools used by financial advisors and a large majority of investors. It is used to make investment decision about commodities, inflation expectation, international businesses and trade impacts to name a few. Although it might be a useful tool in theory, in reality, there are a few problems with it.

A first problem is that unfortunately, this measure is a bit outdated. The US dollar index was created in 1973 by J.P. Morgan with this specific allocation of currencies:

  • Canadian dollar
  • French Franc
  • Deutsche mark
  • Italian Lira
  • Japanese Yen
  • UK Pound sterling

(Note that I was unable to find the proportion used for each currencies, but the bigger the country’s economy of the corresponding currency, the higher weight this currency had). The index was initially set at 100 and the index composition never changed except once, after the creation of the Euro, which the index became composed of:

  • Euro (57.6% weight)
  • Japanese Yen (13.6%)
  • Pound Sterling (11.9%)
  • Canadian dollar (9.1%)
  • Swedish Krona (4.2%)
  • Swiss Franc  (3.6%)

Looking at these, what do you think is most striking? Considering that China has recently surpassed Japan as the 2nd major economy of the world, we would think the Chinese Renminbi would be part of it. In fact, looking at the list of countries with the highest GDP, we realize Brazil, Russia and India should logically be included. See

http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)

They did realize this index was becoming less relevant and therefore introduced the Trade Weighted US dollar index that composes quite a lot more currencies with varying proportions based on other economic indicator.

 

Graph: Trade Weighted U.S. Dollar Index: Broad

Graph: Trade Weighted U.S. Dollar Index: Broad

 

But we must remember that all currencies are falling in value, certainly real now with a currency warfare going on where many countries are devaluing it to get favorable export (which is true initially, but on the long run brings devastation to an economy). Considering all currencies are manipulated by their respective central bank in the “beggar thy neighbor”, can we actually rely on any of those index for what matters: how much will it cost to repair, how much to plan in capital expenditure in the coming year, what could commodity inflation induced in both wage and material cost increases. As long as these numbers are relatively low though, they will be manageable.  In terms of investment planning, a close watch should be kept on the relative changes of commodity prices. A much better index therefore would be the commodity price index.

In short, price inflation results from the increase of supply of currencies such as the dollar. The more dollars there is, the cheaper they are in relations to assets and commodities. It takes a while to affect commodities, it usually start with asset price inflation since the initial driver of currency creation comes from lending by commercial bank. It then later creeps into the rest of the economy to push commodity inflation. Wage inflation comes in at various stages but they will certainly be influenced by food and energy prices as you can imagine. What is important to understand is that this whole process has a non-linear distribution in time and therefore will surprise people. Considering monetary inflation has 2 sources – the commercial bank being the most important one followed by the federal reserve financing the government, the combination of both does bring ups and downs as we see on this chart. But the trend is up, make sure of this so, when managing your real estate investment, plan for higher cost of material in your capital expenditures going forward, similar to what we have experienced since early 2009. With the recent discussion about the $1 Trillion dollar coin, this is an indication they will keep the monetary inflation going.

 

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