The dollar has reached a new low versus the euro. Investors typically fear dollar weakness is a symptom, or precursor to, economic and market weakness. Historically, there's no meaningful correlation between the strength of the dollar and the direction of the stock market. Currencies are a zero-sum game—one being weak makes another strong. Overall, relative currency strength doesn't matter for global investors.
A strong currency—or a strong anything, has a certain cachet. Anything "weak" just sounds bad. Who wants a weak dollar, or even a weak waffle iron, for that matter? But fears a weak dollar is somehow emblematic of a crumbling economy or a harbinger of doom are misplaced.
There's a lot of mythology about what determines relative currency valuations—things like balance of trade, budget deficits, a nation's relative economic standing, even international popularity! But since a currency's relative price is determined—just like all things traded on a free market—by supply and demand, all of these myths are easily debunked.
A more rational driver behind relative currency strength—and one you don't hear about too often—is short-term interest rates (and expectations for future rate moves). When one country has a much lower short-term interest rate than another, folks can borrow to buy currency at the low rate in one country and invest it in the higher yielding currency of the other. This is known as a "carry trade." Done right, it's free money! And it's very rational and quite common. We can see it going on in huge volume in Japan, because for a very long time, Japan has had very low interest rates and the yen has been very weak. It's a bit of a self-fulfilling prophecy—as investors borrow in a weaker currency to buy the higher yielding currency, this puts downward selling pressure on the first and upward buying pressure on the second.
A nation's shortest-term rate usually (but not always) tracks closely with that country's central banking rate (like America's Fed funds rate). Given that our Fed has been lowering (and may continue lowering) rates over the past 22 months, it shouldn't be surprising the dollar has weakened versus other currencies. This is not a reflection of American economic weakness, but a sign carry traders are behaving quite rationally.
So, the weak dollar doesn't necessarily represent fundamental weakness. But with all the hoopla around the weak dollar, surely there's evidence we should fear for markets, right? Not really. Although the trade-weighted dollar is weaker than it was a few years ago, it's pretty much in the same spot it was in the early 1980s or 1992 or 1995—all perfectly fine times for stocks. And the dollar's been weakening nearly the entirety of this bull market run—it hasn't stopped stocks. Conversely, the dollar appreciated considerably against other major currencies in 2001 and 2002, yet stocks did very poorly. A strong dollar wasn't a magical market panacea then. There is simply no meaningful statistical correlation between currency valuation and stock market direction.
What about the economy? Won't a weak dollar harm our economy? Again, there's no historical evidence supporting this fear. America has had cyclical periods of a weak and strong dollar and neither has resulted in a better or worse economy. In fact, while we worry about a weak dollar States-side, the Europeans are worried about a too-strong euro.
ECB's Trichet ‘Concerned' About Euro's Appreciation
By Simon Kennedy and Simone Meier, Bloomberg
Why all the fear? A strong euro (relative to the dollar) makes things like fancy European cars more expensive in the US. So what might a fancy European car maker do?
BMW to Make Fewer Cars in Europe
Staff, BBC News.com
Outsource jobs to the US!
And the reverse is true for US exports—a weak dollar makes good old Yankee ingenuity more affordable overseas. And we've seen US exports surging of late. Interestingly, when the dollar is strong, folks complain it hurts our imports too. So which is it? Is a weak dollar good or bad, and a strong dollar better or worse?
There are pros and cons to both a weak and strong dollar. But neither is predictive for the stock market or inherently better or worse for the economy. Currencies are essentially a zero-sum game—one being weak means another must be strong. But which is weak and which is strong doesn't matter—each is really just a different flavor of a global currency. Maybe the problem isn't that the dollar is weak. Maybe the problem is simply the notion that it's "weak." Don't think of the dollar as "weak"—think of it as mint chocolate chip. There's nothing alarming about that. If you're a global investor, net-net, it really just doesn't matter which flavor you choose in the long run.