Understanding the behaviour of the US Dollar

I have often written about mainstream media missing the bigger picture about the US Dollar. I always wondered how some of the astute commentators, some I respect highly, would miss the bigger picture. I have been asked why, despite my talk about US macro weakness, does the USD appreciate in times of risk aversion. I think I should take one more shot at explaining one aspect of the US Dollar issue.

Dollar behavior is aggregate of multiple forces

The US dollar is influenced by following forces:

1. Adjustment of US economic activity in terms of skill, ability and productivity of the population. 
• With rising capital intensity the minimum qualification requirements are changing. This change is not in sync with the US population in terms of availability of skill, ability and productivity. 
• I know some people will react to inclusion of productivity in the list, but careful assessment will indicate its aptness. 
• This adjustment is rather complex and will take years to play out. Thus the effect of this force, my guess is, will be rather small at the moment. However, once the realization is complete, there may be a drastic impact on the US Dollar.
• This force will augment a devaluation of US dollar.
• In geek-speak, since force is a vector, both the magnitude and direction of this force are not  manifesting itself effectively as yet. The magnitude is small and direction may be opposite to what can be expected.
2. Forces creating adjustment of prices. 
• The term price has two elements to it. First one represents the information about how relative value of goods and services stack up against each other, or simply inter-goods comparison. The Second and more relevant for us is the information about how the value of goods stack up in relation to those in other countries, or simply, price comparison between countries for similar goods. 
• My sense is that relative prices of non-food goods and services are far cheaper in developed economies than in emerging market economies (though not for all products and services). 
• As we establish clarity in this, we will see inflation in USD terms while deflation in other currencies if they let their currencies float to their natural level. However many countries have pegged currencies, particularly those with large dollar reserves. The pegging process will create inflationary forces in these countries as well. Their central banks thereafter will be forced to choose between inflation and losses on external account. It appears they will prefer losses than inflation. 
• This will be devaluing force for the US dollar.
3. Risk Aversion forcing the US Dollar denominated money to return home. 
• One of the tenets of risk aversion is that during such times investor feels safer at home, keeping money in her own currency. It is a fact that US has been biggest investor for some time now and hence risk aversion creates a demand for dollars. 
• The fact to be noted is that this is mostly private investment and hence more fickle.
• This force is supporting the US dollar.
• At the moment, this force has the right magnitude and direction to support US Dollar appreciation.
4. Subdued Capital withdrawal by those with US Dollar reserves - particularly China and Japan. 
• For reasons best known to them China and Japan have continued to pledge their support to the USD. China with nearly 3.2 trillion USD and Japan with 1.1 trillion hold considerable sway in the market. 
• Here the investments are initiated by the respective governments and thus more stable but changes can be abrupt. It is sort of a dormant volcano, if it erupts, there will be tremendous loss. Similarly, if, for any reason, any tiny bit of doubt crops up in these governments, we will see tremendous meltdown.

Interpreting US Dollar movement

It is important to know the forces above and what impact they have on the US Dollar movements. We realize that most of the devaluation forces are diffused and their magnitude is small. However, a keen investor will realize that the alignment between these forces is increasing and we may soon reach a tipping point in favor of devaluation. Further, the forces supporting the US Dollar are fickle and may reverse quite quickly.

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