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INFLATION AND THE DOLLAR
by James A. Bianco 07:00 AM 06|08|2001
A big change in capital flows rearranges the old inflation predictor.
Conventional wisdom has it that the dollar should decline if inflation is a real fear. I disagree. The chart ("More Bull Market Fallout") shows the euro/dollar actual exchange rate from 1999 and "reverse engineered" back to 1985. The interest rate differential between the 10-year German Bund and the 10-year U.S. Treasury note is also shown. For most of the period shown, interest rate differentials and the exchange rate have moved together. When the interest rate differential is "high," meaning that Bund yields are higher than Treasury yields, the euro is very strong. Conversely, when the interest rate differential is "low," meaning that Bund yields are lower than Treasury yields, the euro is weak. The notable exceptions to this pattern are 1986-1988 and the current period. From 1986 to 1988, a combination of the Plaza Accord and the U.S. stock-market crash pushed investors away from the dollar despite the much lower yields offered by the Bund. (The Plaza Accord was a September 1985 agreement in which finance ministers from Japan, the U.S. and Europe pledged coordinated action to push the dollar down.)
What's causing the current divergence? An unwavering belief that U.S. stocks are still in a bull market.
The capital flow patterns of investors in "Europe less the U.K." (the countries that have the euro as their currency) tells the story. From 1978 to 1998, the asset of choice among these investors was U.S. Treasury notes and bonds. During this period, investors never bought more than $10 billion of U.S. equities over any given 12-month period. Since 1998, however, capital flows have dramatically changed. "Europe less the U.K." investors had a 10-fold increase in their purchases of U.S. equities to well over $100 billion a year. At the same time, these investors have become net sellers of U.S. Treasury notes and bonds. Simply put, since 1998, they have sold U.S. Treasury notes and bonds to buy U.S. equities. Furthermore, it is reasonable to assume that most of the equity activity has been concentrated in Nasdaq stocks. We say this because most of this buying has taken place while the Nasdaq was undergoing its parabolic rise and fall. However, there is no data to support this claim.
This flow to U.S. equities has been an almost all-European affair, as the following numbers show: In the 12 months ending March 31, 2001, "All Foreign Countries" were net buyers of $154.01 billion of U.S. equities. Total Europe accounted for virtually all of these purchases -- $140.01 billion. Total Asia was a net buyer of $28.68 billion, while Latin America was a net seller of $22.45 billion. There's no clearer way to say "weak euro."
Inflation vs. Cisco
The argument put forth by many economists is that the dollar's strength is a sign that inflation is under control. If inflation were a problem, the dollar would decline. After all, inflation is supposed to affect interest rates, which, in turn, affect exchange rates. But the interest rate differentials and exchange rates have been diverging since 1998. This also coincides with the shift to U.S. equities among "Europe less the U.K." investors. Had these investors stayed with U.S. Treasury notes and bonds as their primary investment, issues like inflation and interest rate differentials would continue to be very influential on exchange rates. Because they have shifted to U.S. equities as their primary investment, I believe that equity market performance has replaced inflation and interest rate differentials as the primary driver of exchange rates. Simply put, Cisco's stock price might be as important as inflation in influencing exchange rates.
So, what will drive the dollar down? I believe it will happen when investors from "Europe less the U.K." aggressively move out of U.S. stocks. When will this occur? While the circumstances are debatable, I believe it will occur coincidently with domestic investors exiting the U.S. stock market as well. Therefore, watching mutual fund flows should tell us when to expect selling from Europeans.
The chart ("Down But Far From Out") shows the 12-month sum of all equity fund mutual fund flows and the 12-month sum of U.S. equity purchases by "Europe less the U.K."
In recent years, the investing patterns of both of these groups have been very similar. While both are well off their highs, they are still investing hefty amounts of money in the U.S. stock market. I believe that "Europe less the U.K." investors will aggressively sell the U.S. stock market when domestic equity mutual fund investors also aggressively sell U.S. stocks. So, watching mutual fund flows may very well provide insight into the movements of the euro/dollar exchange rate.
James A. Bianco is the president of Bianco Research,, which is based in Barrington, Ill. |
