With NASDAQ down by a third from its year-end peak, America’s capacity to trade paper for goods is diminishing
Measured against a trade-weighted basket of currencies, the US dollar is stronger than it has been in a generation. But are we observing dollar strength, or just weakness of the Eeuro and the Japanese yen? Japan’s government debt stands at a tippy 266% of GDP, vs. only 138% for the United States. It no longer can finance its debt with internal savings as retired Japanese spend their nest eggs. Europe is burdened by weakness on its Mediterranean periphery. The major industrial currencies, that is, are in a race to the bottom.
The dollar has risen as the Federal Reserve tightened monetary policy, in a nearly straight line relationship to the yield on 5-year Treasury Inflation Protected Securities (TIPS).
A different—and more telling—measure of dollar strength is the performance of gold against competing dollar-denominated assets, specifically Treasury Inflation-Protected Securities. Both gold and TIPS offer a form of insurance against a drastic decline in the dollar’s value. At maturity, the TIPS payout is principal plus the percentage increase in the US Consumer Price Index over the life of the security.
During the past fifteen years, we observe a close linear relationship between the yield of 5-year TIPS and the gold price (with an r2 of about 85%) – until 2022, that is. The red dot on the scatter graph below shows the gold price vs. the TIPS yield as of June 14.\
Gold has detached from TIPS. Between November 2021 and June 2022, the 5-year TIPS yield has risen by 2.5 percentage points, but the gold price has barely moved.
The regression analysis below calculates that the gold price is about $600 higher than the historical relationship between TIPS and gold would have predicted. That’s something we have never seen before, not even during the worst of the 2008 panic.
Put another way, investors are willing to pay a considerable opportunity cost in forgone interest income to hold insurance against a future decline in the dollar’s value. TIPS can’t provide the same protection. The US Consumer Price Index fails to capture the actual depreciation of the dollar. As I reported here and on several previous occasions, the 8.3% year-on-year increase in the CPI reported for June doesn’t capture 16% year-on-year rent inflation or 21% year-on-year home price inflation.
That’s why the deviation of the gold price from the regression line with TIPS is the most accurate measure of dollar weakness. The price of insurance against a possible collapse of the dollar in the future has risen to an all-time record. By this gauge, the dollar is weaker than ever.
That shouldn’t be a surprise. The US has built up a negative $18 trillion net foreign asset position, selling assets (mainly stocks and bonds) to foreigners to cover its chronic trade deficit. As long as American tech stocks outperformed the rest of the world’s equity markets, America could ride on bubbly capital inflows. But with the tech-heavy NASDAQ Index down by a third from its year-end 2021 peak, America’s capacity to trade paper for goods is diminishing. And America’s global position has weakened with strategic misadventures, most recently in Afghanistan and Ukraine.
The fact that the price of insurance against a crisis has jumped doesn’t necessarily mean that a crisis soon will be upon us. But it’s a warning that American policymakers will ignore at their peril.