US Dollar Index Dropping – Is Inflation Coming?
publication date: Aug 4, 2010
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author/source: Brad Hamill
The last six weeks has seen the value of the US Dollar Index plummet – going
from over 87 to just over 80. Is the US dollar becoming devalued? Is major
inflation ready to rear its ugly head? Is yours truly, who has been writing
about the US Dollar Index going to 100, a crazed nut who should be ignored? The
answers are No, No, and possibly – depending on whom you confer
with.
Let’s look at the graph. It tells the story:
What makes all of this even more confusing is that precious metals have also been declining somewhat lately. In fact, it was in late July that gold hit a three month low. Shouldn’t gold be going through the roof if the US dollar Index is falling through the floor?
How about stocks? Shouldn’t the stock market be rocketing past 11,000 easily with such a quick decline of the index?
Another curiosity is the fact that the yields (interest) on long-term Treasury notes and bonds have been going down significantly. This means that investors are more than willing to invest their money in 10-year and 30-year securities at paltry rates. Why would they do this if inflation is coming? Why not take that same money and invest it in the stock market, since inflation would allow companies to report higher profits due to having cheaper debt servicing?
It can make one’s head spin.
The other thing that’s hard to figure out is that the European Union’s Euro has rocketed back up in value over the last six weeks. Not to mention the fact that the Japanese yen has also gained tremendous strength during that same period. Is the world now recognizing the “fact” that the US is bankrupt? Are we going to be the first major nation to fail?
How have you done with all of the questions? Do you feel like you have a firm grasp on the answers? The real answer might surprise you. Let’s go back to the basics.
What is inflation? Inflation is an increase in the money supply (including credit) for a relative supply of goods and services. The increased money supply will be absorbed into the economy, which will make prices increase and make the value of each unit of currency be worth less.
What is deflation? Deflation is a decrease in the money supply (including credit) for a relative supply of goods and services. The decreased money supply will make each unit of currency more valuable, and will decrease prices as the suppliers of goods and services compete for a reduced pool of money.
Fair enough?
A strengthening currency can be a great thing, if it comes about through a higher demand for goods and services against a relatively fixed level of currency. Each unit of currency becomes more valuable as consumers seek them in order to purchase things. This is a sign of a healthy economy (except for the fact that it is debt-based).
A strengthening currency can be very bad if it is a result of deflation. People will have a desire to buy the necessities, but there will only be a certain amount of currency to go around. Many will face great hardship through layoffs, reduced salaries, decreased benefits, losing homes, bankruptcy, etc.
Here’s the question. Are the strengthening currencies of the European Union and Japan a result of high consumer demand against a relatively fixed supply of currency? Or are they a result of a decreasing amount of currency via the collapse of credit in those economies?
It’s pretty easy to see that the second case is what the truth is. The European Union and Japan have not become healthy economies all of a sudden. Instead, they have recently taken an even more severe economic downturn – and their money supplies are taking an absolute beating. This has caused the rapid increase in the value for each unit of currency in those economies.
By now you should be asking yourself what all of this has to do with the US Dollar Index. Why is it supposedly showing a nation in more dire straits than anyone else – although through inflation instead of deflation?
To answer this question we need to look at what the US Dollar Index measures. It is simply a “weighted” index that measures the US Dollar against a set of six other currencies. Here is the formula: US Dollar Index = 50.14348112 * ((EURUSD ^ 0.576) * (JPYUSD ^ 0.136) * (GBPUSD ^0.119) * (CANUSD ^ 0.091) * (SEKUSD ^ 0.042) * (CHFUSD^.036) ). This looks somewhat intimidating, but it is actually very simple. We see that 57.6% of the currency values in the index is measured against the Euro. Likewise, 13.6% is calculated against the yen. In other word, a full 71.2% of the currency component in the US Dollar Index is measured against the Euro and yen! The 50.14348112 value at the beginning of the formula was just placed there to adjust the index value to 100 at the time it was first put in place.
The next thing you need to keep in mind is that an increase in any of the currencies that make up the index will cause it to go down in value. This means that these other currencies have greater “strength” (or are more deflationary in this case) than the US dollar.
Let me put it more simply. The purchasing power of the US dollar itself is not going down, even though the US Dollar Index makes it look like it is. The rush to buy US Treasury securities at extremely low yields already told us that. Instead, the European Union and Japan are falling off a deflationary economic cliff even faster than we are. The European Union does not have the ability to issue debt on behalf of any of its member countries. Japan is at the end of its 20+ year deflationary rope. The US is still able to sell vast amounts of US Treasury securities to willing investors to make it appear like we’re not in a major depression yet.
Be careful in the weeks ahead as the media attempts to spin the falling US Dollar Index. Look at the “strengthening” currencies of the European Union and Japan to assist you in recognizing the real story.
Also, look for the US Dollar Index to resume its upward trend at some point as the US falls further into deflation, eventually overtaking the pace of other nations.
Your comments are appreciated…
If you are not currently on the Economic Update email list you can email Brad Hamill at: brad@newfamilyeconomics.com to be added.
There is no charge and your email address will never be shared.
Let’s look at the graph. It tells the story:
What makes all of this even more confusing is that precious metals have also been declining somewhat lately. In fact, it was in late July that gold hit a three month low. Shouldn’t gold be going through the roof if the US dollar Index is falling through the floor?
How about stocks? Shouldn’t the stock market be rocketing past 11,000 easily with such a quick decline of the index?
Another curiosity is the fact that the yields (interest) on long-term Treasury notes and bonds have been going down significantly. This means that investors are more than willing to invest their money in 10-year and 30-year securities at paltry rates. Why would they do this if inflation is coming? Why not take that same money and invest it in the stock market, since inflation would allow companies to report higher profits due to having cheaper debt servicing?
It can make one’s head spin.
The other thing that’s hard to figure out is that the European Union’s Euro has rocketed back up in value over the last six weeks. Not to mention the fact that the Japanese yen has also gained tremendous strength during that same period. Is the world now recognizing the “fact” that the US is bankrupt? Are we going to be the first major nation to fail?
How have you done with all of the questions? Do you feel like you have a firm grasp on the answers? The real answer might surprise you. Let’s go back to the basics.
What is inflation? Inflation is an increase in the money supply (including credit) for a relative supply of goods and services. The increased money supply will be absorbed into the economy, which will make prices increase and make the value of each unit of currency be worth less.
What is deflation? Deflation is a decrease in the money supply (including credit) for a relative supply of goods and services. The decreased money supply will make each unit of currency more valuable, and will decrease prices as the suppliers of goods and services compete for a reduced pool of money.
Fair enough?
A strengthening currency can be a great thing, if it comes about through a higher demand for goods and services against a relatively fixed level of currency. Each unit of currency becomes more valuable as consumers seek them in order to purchase things. This is a sign of a healthy economy (except for the fact that it is debt-based).
A strengthening currency can be very bad if it is a result of deflation. People will have a desire to buy the necessities, but there will only be a certain amount of currency to go around. Many will face great hardship through layoffs, reduced salaries, decreased benefits, losing homes, bankruptcy, etc.
Here’s the question. Are the strengthening currencies of the European Union and Japan a result of high consumer demand against a relatively fixed supply of currency? Or are they a result of a decreasing amount of currency via the collapse of credit in those economies?
It’s pretty easy to see that the second case is what the truth is. The European Union and Japan have not become healthy economies all of a sudden. Instead, they have recently taken an even more severe economic downturn – and their money supplies are taking an absolute beating. This has caused the rapid increase in the value for each unit of currency in those economies.
By now you should be asking yourself what all of this has to do with the US Dollar Index. Why is it supposedly showing a nation in more dire straits than anyone else – although through inflation instead of deflation?
To answer this question we need to look at what the US Dollar Index measures. It is simply a “weighted” index that measures the US Dollar against a set of six other currencies. Here is the formula: US Dollar Index = 50.14348112 * ((EURUSD ^ 0.576) * (JPYUSD ^ 0.136) * (GBPUSD ^0.119) * (CANUSD ^ 0.091) * (SEKUSD ^ 0.042) * (CHFUSD^.036) ). This looks somewhat intimidating, but it is actually very simple. We see that 57.6% of the currency values in the index is measured against the Euro. Likewise, 13.6% is calculated against the yen. In other word, a full 71.2% of the currency component in the US Dollar Index is measured against the Euro and yen! The 50.14348112 value at the beginning of the formula was just placed there to adjust the index value to 100 at the time it was first put in place.
The next thing you need to keep in mind is that an increase in any of the currencies that make up the index will cause it to go down in value. This means that these other currencies have greater “strength” (or are more deflationary in this case) than the US dollar.
Let me put it more simply. The purchasing power of the US dollar itself is not going down, even though the US Dollar Index makes it look like it is. The rush to buy US Treasury securities at extremely low yields already told us that. Instead, the European Union and Japan are falling off a deflationary economic cliff even faster than we are. The European Union does not have the ability to issue debt on behalf of any of its member countries. Japan is at the end of its 20+ year deflationary rope. The US is still able to sell vast amounts of US Treasury securities to willing investors to make it appear like we’re not in a major depression yet.
Be careful in the weeks ahead as the media attempts to spin the falling US Dollar Index. Look at the “strengthening” currencies of the European Union and Japan to assist you in recognizing the real story.
Also, look for the US Dollar Index to resume its upward trend at some point as the US falls further into deflation, eventually overtaking the pace of other nations.
Your comments are appreciated…
If you are not currently on the Economic Update email list you can email Brad Hamill at: brad@newfamilyeconomics.com to be added.
There is no charge and your email address will never be shared.
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