The message behind the dollar, equity markets and earnings.

By Mike Lenhoff 15:38 13- Oct -2009

Upward sloping yield curves, particularly those that are steeply sloping, such as that shown in the chart for the US Treasury market, are usually indicative of an expansion ahead but they also convey the sense in which monetary policy is easy and needs to tighten eventually. We say eventually because in the US the yield curve has generally not begun to flatten materially before employment starts growing.

Typically, the Fed starts tightening only after jobs are growing. In the US, the trend rate at which jobs are being shed is diminishing but it will be some months yet before employment starts growing again and therefore some months before the Fed starts to raise interest rates.

Will a weak dollar force the Fed to increase interest rates sooner rather than later? A weak dollar raises global purchasing power for dollar-related goods and services. It helps to reflate the dollar related economies - which include China because of the renminbi’s peg with the dollar. Thus, to the extent it stimulates demand a weak dollar is good for employment or, in the present case, less bad for it and, by forcing up prices for dollar priced goods and services, is somewhat inflationary.

Any concern that this will bring forward the day of reckoning on monetary policy should register initially in the Treasury market but no concern is apparent. Gold has been rising and other commodity prices are up a bit too. However, breakeven inflation rates in the US Treasury market are still around 2 percent, which is where they have been for a number of months. Also, the trend of yields at the long end of the Treasury market, which has been downward since June, has yet to be broken and yields at the short end have not budged (note the top chart on the next page).

In a recent speech on the Federal Reserve’s balance sheet, Mr Bernanke said that, while policy will have to be tightened as the recovery takes hold ‘to prevent the emergence of an inflation problem down the road’, he also said that both he and his colleagues at the Fed believe ‘accommodative polices will likely be warranted for an extended period’. Granted, the Fed Chairman did not repeat the mantra in quite the same way it appears in FOMC statements but it is more or less the message the Fed has been delivering and the one it wants the Treasury market to buy into.

Low yields at the long end of the Treasury market are helping conventional mortgage rates come down and so helping to stabilize the housing market but they are also helping to reflate asset values across the board. The reflation of asset values is all part of rebuilding balance sheets and getting the economy going again - just what the Fed and the rest of us want.

In trade weighted terms the dollar reached an all-time low in March 2008. Over the course of the next twelve months - and against the recession backdrop - the dollar appreciated to this year’s high point in March. Since then, the continued slide in the dollar has coincided with the recovery that is now under way in the global economy. Not only has the weakness greatly enhanced the international competitive position of dollar earners but also it has been doing so at a favourable stage of the cycle.

As a very crude approximation we estimate that, all other things equal, a 10 percent depreciation in the dollar, as measured by its trade weighted index, boosts earnings for the S&P 500 by between 4 and 8 percent with a two to three quarter lag. This means that the dollar’s 15 percent depreciation since March of this year should be starting to come through with the third quarter’s results and, spread over this quarter and next, could be adding something in the range of 6 to 12 percent to earnings.

Over the past two quarters, much of the improvement in bottom line growth has been due to cost cutting and restructuring, which is fine for starters and, frequently, the way corporate recoveries proceed. However, sustainable recoveries are not built on this.

Thus, now that a recovery is in the formative stages of development, I suspect that what equity markets will be looking for is not only an improvement in the top line but both an improvement and promising guidance in sectors most likely to be associated with an upswing in the cycle such as consumer discretionary, industrials, technology and, of course, financials to name a few.  

Not only has the Fed’s message on interest rates encouraged investors to be that much less risk averse but it has also been partly why the dollar has weakened all year and why equity markets have made such an astonishing and resolute comeback. Until the message changes, which is a prospect that still seems months away, there is little reason to think that the downward pressure on the dollar will abate or that equity markets will lose their firmness of tone.