Economics
3rd July 2003
AUSTRALIAN RESEARCH
Unravelling the US Dollar Puzzle
What Drives the US Dollar?
The US dollar strengthened significantly by around 17½%
from early 2000 to mid 2002. The underlying strength of
the US economy and the attractiveness of returns in the
1
Chart 1: US TWI and Euro (Inverse)
Jeff Oughton
Senior Economist
+(613) 8641 3469
Jeff_Oughton@national.com.au
0.80
110
105
US TWI (LHS)
EURO(RHS)
0.90
100
1.00
95
Cents
1.10
90
1.20
85
1.30
80
1.40
75
70
1.50
Q2 87 Q2 88 Q2 89 Q2 90 Q2 91 Q2 92 Q2 93 Q2 94 Q2 95 Q2 96 Q2 97 Q2 98 Q2 99 Q2 00 Q2 01 Q2 02
The US TWI has subsequently fallen by around 13½%
from its mid 2002 peak, while the Euro/$US has
appreciated by around 24% over this period. The recent
decline of the US dollar has been attributed to various
factors including, the sustainability of the size of the US
current account by increasing the risk premium, the
patchy economic performance and narrowing interest rate
differentials. While these explanations are all intuitively
appealing, there is little empirical evidence of their causal
relationship.
2
Major Currency TWI.
Alan Oster
Chief Economist
+(613) 8641 3464
Alan_Oster@national.com.au
US (especially during the technology boom) have been
claimed as the main justifications for US dollar strength
over this period. On the other hand, the slower pace of
growth in the Euro area and structural labour and product
market rigidities were said to be the main cause of the
Euro’s weakness. The movement in the US dollar over
this period was reflected in many global currency crosses,
especially the Euro. Japan’s declining trend economic
growth since the late 1980s suggests that it has not been
a viable option for investors, hence the flow of capital has
been largely between the Euro area and the US. Indeed
2
the inverse of the synthetic Euro has been the mirror
image of the US TWI (see chart below).
Index Points
1
Since mid 2002 the US dollar TWI has depreciated by
around 13½%, resulting in significant movements in
international currency crosses, and for that matter,
interest rates. A critical question presently for global
currencies (including the $A) and global interest rate
settings is whether US dollar weakness will persist. Many
analysts have recently revised their exchange rate and
interest rate forecasts, assuming a weaker US dollar will
continue in the medium-term, mainly on the basis that a
correction in the US dollar is long overdue given
fundamentals, especially a high current account deficit to
GDP ratio. On the other hand, some believe that the
weakness in the US dollar is short-lived, and expect a
bounce in the currency once signs of an economic
recovery in the US emerges. Some strengthening in the
US dollar in recent weeks, may be supportive of that
scenario. While many views of the US dollar abound,
there is little statistical evidence supporting the
arguments. This research paper takes a close look at the
US dollar and finds a stable relationship between the US
dollar TWI and the trend productivity ratio between the US
and the Euro area since mid 1987. Granted this
relationship continues to hold in the foreseeable future,
our model sees the US TWI weaken moderately further.
Current economic growth forecasts for the US and Europe
are consistent with further moderation in the trend
productivity ratio, resulting in an easing in the US dollar
(TWI) to around 89 cents and the Euro/$US strengthening
slightly to around 1.18 by the end of 2005. The direction of
the US dollar has important implications globally and
locally. For instance, if our forecasts are right, in the US it
may alleviate any deflationary pressures and the need for
further rate cuts. Domestically a weaker US dollar
increases the prospect of the $A/$US making further
gains to the low 70s in 2004 and staying around 65-67 US
cents in 2005. A stronger local currency will result in
tighter monetary conditions, allowing the cash rate to
move slightly lower in the near-term or delay the need for
rate increases.
Before 1999, the Euro is proxied by the Deutschmark.
Jennifer Babet
Economist
+(613) 8641 3762
Jennifer_M_Babet@national.com.au
National Australia Bank
Economics
3rd July 2003
AUSTRALIAN RESEARCH
This paper attempts to model the US TWI. As forecasting
of equity returns is difficult, the focus is placed on
fundamental economic drivers. Fundamental models are
useful for long-term forecasting i.e. not for daily or weekly
forecasts. As a starting point, trend GDP growth
differentials between the US and Europe were used as a
proxy for relative returns but did not yield any significant
results. On the other hand, a surprisingly robust
relationship was found between the US TWI (and the
Euro/$US) and the trend productivity ratio between the US
and the Euro area since mid 1987 (see below). On the
other hand, this variable cannot explain the mid 1980’s
spike in the US dollar. The trend productivity ratio has a
better fit with the US TWI rather than the Euro/$US. This
relationship may have developed since 1987 due to
Japan’s economic problems. Consequently, it is possible
that the link may weaken once Japan’s economic malaise
is overcome – not a medium-term prospect.
Chart 2: US TWI and Trend Productivity Ratio
US TWI
Chart 3: US Productivity
7.00
Productivity - Output per Hour
GDP/Employment
5.00
3.00
1.00
Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1
-1.00 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
-3.00
7.00
US productivity growth has consistently outpaced
European productivity growth since the late 1990s. This
has been attributed mainly to more high tech industries
and a higher take-up of technologies in the US. That said,
European productivity growth has been adversely
impacted by increased employment growth in low
productivity areas. While US productivity continues to
significantly exceed the Euro area (see chart below), the
ratio peaked in early 2002 and has subsequently
narrowed.
6.00
Chart 4: Trend Productivity Growth
3
120
To ensure consistency in the productivity measures, GDP
divided by employment was used. The official productivity
growth for the US has been higher in recent years than
GDP/employment (see chart below), however, the latter
appears to have more explanatory power for the US TWI
or Euro/$US.
Annual % change
We use a Major Currency measure of the US TWI in the
paper. This gives weight largely to the Canadian dollar
(30.3%), Euro (28.7%), Japanese Yen (25.6%) and UK
pound (8.0%). This measure attempts to capture financial
pressures on the US dollar, as well as the
competitiveness of US goods relative to major economies.
Undoubtedly capital flows rather than trade flows have
been a major driver of currencies in recent years.
According to the Bank of International Settlements (BIS)
2001, the Euro/$US accounts for around 30% of global
foreign exchange turnover, the Yen/$US 20% and the
Pound/$US 11%.
Productivity
110
5.00
3
100
3.00
2.5
Ratio
Index Points
4.00
2.00
2
90
80
0.00
Ratio
1.00
1.5
-1.00
1
70
-2.00
Q2 87 Q2 88 Q2 89 Q2 90 Q2 91 Q2 92 Q2 93 Q2 94 Q2 95 Q2 96 Q2 97 Q2 98 Q2 99 Q2 00 Q2 01 Q2 02
0.5
EURO AREA
US
0
3
Trend based on Hodrick Prescott filter smoothing factor 1600.
Unravelling the US Dollar Puzzle
Q2
84
Q2
85
Q2
86
Q2
87
Q2
88
Q2
89
Q2
90
Q2
91
Q2
92
Q2
93
Q2
94
Q2
95
Q2
96
Q2
97
Q2
98
National Australia Bank
Q2
99
Q2
00
Q2
01
Q2
02
2
Economics
3rd July 2003
AUSTRALIAN RESEARCH
The productivity relationship also accords well with assetmarket/portfolio-based theories as productivity is closely
linked to future returns/profits, income and economic
growth. For instance, the late nineties was a virtuous
economic circle in the US, with increased productivity
associated with the technology boom resulting in
expectations of higher profits and incomes, the surge in
the NASDAQ, increased wealth effects on consumption,
increased capital inflow (higher current account deficit),
strong business investment and higher overall economic
growth. In contrast, the reduction in the trend productivity
differential, points to lower relative future profits/equity
returns, reduced wealth effects on consumption and
investment, lower economic growth and reduced capital
inflow.
US Dollar To Weaken Moderately Further
Chart 2 showed a close relationship between the US TWI
and the trend productivity ratio. Nevertheless, there was
no evidence of cointegration using the Johansen
Maximum Likelihood methodology. On the other hand, the
error correction term is quite large and highly significant
suggesting otherwise. Nontheless, the US TWI has been
modelled using a Vector Error Correction Model (VECM)
framework over the period 1987:2 to 2002:4. This method
includes both the long-run relationship between the
variables, and the dynamic adjustment. The coefficient on
the trend productivity ratio in the long-run equation is 6.4,
suggesting that a 1% increase in the relative productivity
ratio results in an appreciation in the US TWI by 6.4 index
points. The error-correction term is -0.37, indicating fairly
rapid adjustment to the long-run. The fit of the equation
(both long-run and short-run) against the actual US TWI
4
We have modelled the nominal exchange rate rather than the
real exchange rate. Nominal and real exchange rates have been
highly correlated in recent years.
Unravelling the US Dollar Puzzle
are shown in the chart below. A forecast of the US TWI
until the end of 2005 is also shown on the chart.
Chart 5: Forecast US TWI
120
110
(F)
Index Points
100
90
80
70
longrun
actual
shortrun
60
Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4
87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
Assuming economic growth in the US averages around
2½% in 2003, 3¾% in 2004 and 3¼% in 2005, while the
Euro area records economic growth of around 1% in
5
2003, 1¾% in 2004 and 2% in 2005 are consistent with
weaker trend growth in productivity in the US and
strengthening trend productivity growth in Europe over the
next two years (see chart below). This sees the trend
productivity (GDP/employment) ratio continuing to narrow,
resulting in the US TWI easing moderately further to
around 89 Index points by the end of 2005.
Chart 6: Forecast Trend Productivity
3
2.5
2
Annual % change
How does the relationship between productivity and the
exchange rate reconcile with economic theory? Some
economic theory suggests that increased productivity
results in lower prices, a deterioration in the terms of
trade, resulting in a depreciation in the currency (real
4
exchange rate ). On the other hand, the BalassaSamuelson theory makes the distinction between the
price of traded and non-traded goods and predicts that if
the productivity of traded goods relative to non-traded
goods is growing faster in the home country relative to
abroad, then there should be a real appreciation of the
home country’s real exchange rate.
1.5
1
Euro Area
US
0.5
0
Q2
87
5
Q2
88
Q2
89
Q2
90
Q2
91
Q2
92
Q2
93
Q2
94
Q2
95
Q2
96
Q2
97
Q2
98
Q2
99
Q2
00
Q2
01
Q2
02
Q2
03
Q2
04
Q2
05
These are close to the latest Consensus Forecasts.
National Australia Bank
3
Economics
3rd July 2003
AUSTRALIAN RESEARCH
Of course, these forecasts are highly sensitive to the
growth assumptions used, which will also depend on the
currency. The results suggest that US economic growth
will need to significantly outpace the Euro area to result in
the US TWI strengthening markedly. Similarly, the results
suggest that provided US productivity growth continues at
a reasonably strong pace, an abrupt adjustment to the US
dollar should be avoided. While productivity growth is
expected to remain strong in the US, the consensus is
that technological innovation and its take-up is unlikely to
be sustained at the rates observed in the late 1990s. That,
together with the shock from the bursting of the equity
market bubble, point to some further easing in relative
trend productivity. On the other hand, after falling
significantly since mid 1995, trend productivity in Europe
has turned and assuming the above growth projections,
will strengthen further.
What About the $A/$US?
The $A/$US has also been closely linked to the US dollar
TWI, however, only since March 2000 (see chart below).
the $A/$US is now inside the standard error bands of the
old long-run model (see chart below). The long-run model
points to the $A/$US strengthening to around 71 cents by
early 2004 and moderating slightly to around 65 US cents
by the end of 2004, as the Australian/US interest rate
differential narrows. Underlying this projection is a
moderate global economic recovery (CRB increases
modestly), the cash rate ranging from 4¼% in September
2004 to 5% by the end of 2004 in Australia and the
Federal Funds rate rising progressively to 2¼% by the
end of 2004 from 1% currently in the US.
Chart 8: Fundamental $A/$US Model
$A/$US
1
standard error band +/- 4 cents
0.9
(f)
0.8
0.7
Chart 7: US TWI and $A/$US
0.6
50
1
0.5
60
0.9
Actual AUD
0.4Feb-84 Dec-85 Oct-87 Aug-89 Jun-91 Apr-93 Feb-95 Dec-96 Oct-98 Aug-00 Jun-02 Apr-04
70
Jan-85 Nov-86 Sep-88 Jul-90 May-92 Mar-94 Jan-96 Nov-97 Sep-99 Jul-01 May-03
80
0.7
90
Index Points
US cents
0.8
0.6
100
0.5
AUD (LHS)
US TWI INVERSE (RHS)
0.4
110
120
Dec-83 Jun-85 Dec-86 Jun-88 Dec-89 Jun-91 Dec-92 Jun-94 Dec-95 Jun-97 Dec-98 Jun-00 Dec-01 Jun-03
Prior to March 2000, the $A/$US had a stable relationship
with the CRB, interest rate differentials and/or relative
equity returns. However, from early 2000 until more
recently, a long-run equation using those variables
performed poorly, with the actual currency falling well
outside the standard error bands of the long-run equation
– close to 20 cents below the long-run model forecast in
early 2001. At the time, it was difficult to gauge whether
this break was permanent or transient. However, it is now
evident that the break was due to US dollar strength. As
the spike in the US TWI has now almost fully unwound,
Unravelling the US Dollar Puzzle
Implications for Monetary Policy
In the US, the Federal Reserve recently cut the Federal
Funds rate by a further 25 bps to 1%, mainly on concerns
of deflation. A reduction in price pressures in the US
largely reflects excess capacity following the bursting of
the equity market bubble and also continued solid growth
in productivity. Although the US is a closed economy, a
weaker currency will bode well for the expected US
economic recovery, assist to reduce deflationary
pressures and potentially the need for further rate cuts.
The ECB cut its Repo rate by 50 bps in early June, mainly
due to ongoing patchy economic data, the realignment of
the Euro and the benign inflation outlook. The
appreciation of the Euro is hurting German manufacturers.
Given prospects of the Euro/$US strengthening mildly to
around 1.18 US dollar, and little flexibility for fiscal policy
(due to the Stability and Growth pact) the ECB may ease
a further 50 bps in coming months.
National Australia Bank
4
AUSTRALIAN RESEARCH
Economics
3rd July 2003
In Australia, further appreciation in the $A/$US will result
in a some tightening in monetary conditions. Whether the
RBA should respond to movements in the exchange rate
depends on whether the change in the currency is
transitory or longer-term. As shown in this paper, the
adjustment in the US dollar appears to be longer-term,
raising prospects that the strengthening in the $A/$US
may persist. With domestic demand set to slow over the
next year and the global economic recovery expected to
be modest, the higher $A/$US allows the RBA to ease
monetary policy moderately in coming months or delay for
longer any upward adjustments.
Jennifer_M_Babet@national.com.au
Unravelling the US Dollar Puzzle
National Australia Bank
5
Economics
3rd July 2003
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