Why the Swiss Franc is my Favorite US Dollar Barometer

Whenever I analyze the value of the dollar, either on its own or as a benchmark to compare with one or more commodities, I almost always use the US Dollar/Swiss Franc exchange rate (USD/CHF), which is the number of Swiss Francs you can get for one dollar. This may strike some people as strange, insofar as there exists another instrument, the US Dollar Index, which is designed specifically to provide a snapshot of the dollar's global worth. The USDX, as it's called, compares the dollar to a weighted basket of other world currencies, specifically the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona, and Swiss Franc. The idea is that by having a basket such as this, the effects of bi-national issues on currency prices should be minimized by the other currencies in the basket. It's a good enough barometer for most cases, but there's a few reasons why I prefer the Swiss Franc:

1. The weighting of the currencies, though based on real economic data, is somewhat arbitrary. Currently for example, 57.6% of the weighting falls to the Euro, as it was determined that that percentage is how much the dollar is affected by that currency. If geopolitical relationships were to change at all, that 57.6% (or any other weighting) becomes less meaningful.
2. Since most of what I'm writing about concerns comparisons of the dollar's strength with commodity values, I need a barometer that can gauge the dollar's worth in global commerce. Surprisingly, the USDX is not the index used to gauge how strong the dollar is in global trade; that honor falls to the Trade-Weighted US Dollar Index, which is a basket of about 27 or so foreign currencies, weighted by trade volume with the United States, and adjusted annually as trade volumes change year to year. You might think that this index would make a better currency barometer, but the fact that it's changing every single year actually makes it difficult to use when gauging long-term trends. Within a single year it's great, but otherwise you run into consistency problems.
3. This is a bit more of an aesthetic reason, but the USDX is not a real currency. Like all indices, it had to be assigned an arbitrary starting value on a given date which, in this case, happens to be 100 as of March, 1973. So, when I read that the USDX is trading at 78, that means that the dollar is 22% weaker today against an oddly weighted basket of currencies than it was in March 1973. Sweet, good to know. No, when considering the value of the dollar, I want a tangible gauge. I want to know how many units of another nation's currency my hard-earned greenback will actually buy me. I can't walk into a bank tomorrow and say: "I'd like to exchange $100 for 57.8% Euros, 13.6% Yen, 11.9% Pounds Sterling, etc. etc." Well, I guess I could, but I'd look like an idiot.

All of that explains why I prefer not to use the USDX, but why the Swiss Franc? The nation of Switzerland has basically two major economic sectors (three if you count cheese with holes in it): high-end watches, and banking. The country is essentially a giant bank. Its historic neutrality protects it from major geopolitical upheaval and it's terrain makes it largely impenetrable in the event of a new world conflict. Its vast stores of gold give the economy a fundamental and irrefutable value, while its conservative approach to asset management make it's currency extremely stable. Because of Switzerland's limited industrial focus, the United States will almost never be in any sort of trade dispute with the country, unlike, say, with the EU, Japan, China, England, or even Canada, where trade relationships are intricate and new regulations, national or international, can have more dramatic effects on currency values. Because of Switzerland's unique status on the world stage, its exchange rate with the dollar truly lets you know how much the dollar is worth to the rest of the world.

I've been to Switzerland twice, it's a beautiful country, one I hope to return to some day. On my most recent trip there (in 2005) I held onto a SFr 5.00 coin, which today sits on my night stand and which I'll occasionally throw into my pocket if I need a bit of good luck. It is my favorite piece of legal tender I've ever possessed; hefty but not too bulky with beautiful engraving on each side. At the time I acquired it, the coin was worth about $3.85, as of this writing, it's worth about $4.80. Given what's happened to the US Economy between 2005 and 2010, that seems just about right.

Oil and the Dollar, 2008 vs 2009

As a follow up to my post last Monday, I went ahead and did a little statistical regression analysis on the correlations between Crude Oil and the US Dollar/Swiss Franc exchange rate (my favored dollar value barometer), and compared the 2008 correlations with those of 2009.

Here's a plot of 2008's Crude Oil prices vs. the USD/CHF exchange rate (Swiss Francs per US Dollar), both end of day prices:

And here's the same plot for 2009:

2009's plot looks a little bit better.

Running a full regression analysis on the 2008 linear model gives me the following output:

Coefficients:

Estimate Std. Error t value Pr(>|t|)

(Intercept) 495.79 21.82 22.72 <2e-16>

dollar08 -365.87 20.13 -18.18 <2e-16>

---

Signif. codes: 0 ‘***’ 0.001 ‘**’ 0.01 ‘*’ 0.05 ‘.’ 0.1 ‘ ’ 1

Residual standard error: 18.72 on 250 degrees of freedom

Multiple R-squared: 0.5692, Adjusted R-squared: 0.5675

F-statistic: 330.4 on 1 and 250 DF, p-value: <>

vs 2009's:

Coefficients:

Estimate Std. Error t value Pr(>|t|)

(Intercept) 311.029 6.946 44.77 <2e-16>

dollar09 -229.369 6.393 -35.88 <2e-16>

---

Signif. codes: 0 ‘***’ 0.001 ‘**’ 0.01 ‘*’ 0.05 ‘.’ 0.1 ‘ ’ 1

Residual standard error: 5.399 on 250 degrees of freedom

Multiple R-squared: 0.8374, Adjusted R-squared: 0.8367

F-statistic: 1287 on 1 and 250 DF, p-value: <>

That's right. The 2008 Oil Price/Dollar Strength correlation was about .57, while 2009's was about .84 (the bolded, red R_Squared numbers). That means that in 2008, about 57% of oil's price variation could be attributed to its relationship with the dollar. By contrast, in 2009, about 84% of the variation in the price of oil could be attributed to its relationship with the dollar. (NB: If I really fudge around the data and institute a lag, I can get an R_Squared as high as 75% for the 2008 correlation, but that's with a 12-day lag, compared to 2009's day-of correlation which, incidentally, does not improve whatsoever with a lag. Still, even optimized as much as is possible, 2009's correlation is significantly greater than 2008's.)

So in the short time of one year, we've seen the correlation between the value of the dollar and the price of oil increase dramatically. The thing to keep in mind is that with bivariate data such as this, R_Squared doesn't care which variable is dependent upon which, so while today I'm happily discussing how oil prices are affected by the dollar, I could just as well be saying the reverse. And as I've said before, as the global economy grows and emerging powers such as India and China begin consuming greater amounts of oil, it may not be long before we no longer discuss how a strong dollar drove oil prices higher, but rather how skyrocketing global oil prices turned the dollar into a worthless currency.

Full Disclosure: Short March 2010 Mini Crude Oil (QMH10) as of writing.

Breaking the US Dollar/Commodities Link?

Yesterday's WSJ ran a report on how commodities prices appear to be shifting such that they are no longer as closely linked to the US dollar. Historically, as most all commodities are priced in US Dollars (by virtue of their being listed on US Exchanges), there has been an inverse correlation between the strength of the dollar and the prices of commodities; as the value of the dollar goes up, commodities' prices go down. This makes sense, as a weaker dollar means you'd have to use more of those weak dollars to purchase the same amount of some object.

If the WSJ report is accurate, this could be a startling trend. Let's take a look. Here's the AMEX Dollar Index over the last year:

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View the full INDEX:DXY chart at Wikinvest

And here's three major commodities often used to gauge the strength of the dollar, and the economy in general: Gold, Oil, and Copper over the last year (respectively):

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View the full FUTURE:GC00 chart at Wikinvest

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View the full FUTURE:CL00 chart at Wikinvest

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View the full FUTURE:HG00 chart at Wikinvest

Huh. I don't seen any sort of positive correlation there, it looks like textbook inverse correlation. What the hell are they... oh, wait (from the article):

"But since the end of November, both the dollar and commodity prices have been gaining ground."

Since the end of November? You're talking about a sample size of one month, which, with all the holidays and weekends and other gaps in trading, results in about 22 data points. And if I look at those graphs on a one month horizon (the charts are dynamic, just change the time horizon to 1m) I see oil and copper following a general upward trend, while gold is looking like the bottom of a parabola, and the dollar seems to have peaked right around December 22 and has been gradually working it's way down since then. Actually, gold and the dollar look to be in close inverse synchronicity (what one would call the "usual tie" that this article purports they are breaking) while oil and copper appear to have very little correlation with the dollar. In fact, if I plot the correlation, between the price of oil and the USD/CHF exchange rate for the month of December (as that was the data I had available), we get this, oh so meaningless scatter plot:

And a full regression analysis yields an R_Squared value of .04717 (adjusted R_squared of -.0004742). So no, Wall Street Journal, you are incorrect, dollar and commodities prices are not gaining ground together, though they DO seem to be casting off the shackles of their typical inverse correlation.

The headline should have read: "Dollar's correlation with some commodities appears to have weakened over an incredibly specific and short period of time."

Color me underwhelmed. If this trend keeps up for all of 2010, okay, then you've got something.

Full Disclosure: Short March 2010 Mini Crude Oil (QMH10) as of writing.

Forget Gold, America is on the Crude Standard

Almost every single day in 2009, the Wall Street Journal commodities report said something to the effect of:

"Oil prices moved [up/down] on reports of global reserves potentially [shrinking/growing]. Also contributing to oil's movement was expectation of the dollar's [weakening/strengthening]."

Now, perhaps because I still like to read my paper on paper, I have the luxury of witnessing an illuminating if unintentional juxtaposition; the WSJ's currency report, about four days a week, appears on the same page as the commodity report - often immediately adjacent. And almost every single day, each section runs some sort of chart showing (respectively) oil prices, and the US Dollar's value over some period of time. Let's cut to the chase...

Here's oil prices (continuous front-month oil futures on the NYMEX) for all of 2009:

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View the full FUTURE:CL00 chart at Wikinvest

And here's my proxy for dollar strength, the Dollar to Swiss Franc* conversion rate over 2009:

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View the full FOREX:CHF chart at Wikinvest

Notice anything interesting? The prices are moving in almost perfect inverse synchronicity. That is to say, when the dollar is strong, oil gets cheap, and vice versa. Now naturally, that is to be somewhat expected; the law of supply and demand assumes the resultant "price" is reported in a single currency, but in the real world it doesn't work like that. If supply and demand do not change, the value of the good can be expected to change in relation to the value of the currency in which that good is priced. In this way, a correlation between oil prices and the value of the dollar makes sense. However the sort of extreme correlation seen here over the past year is pretty ridiculous. (For comparison, go check out the oil and USD/CHF charts on, say, a five or ten year horizon, the correlation all but disappears.)

Now where this observation gets interesting is in determining which variable is dependent on which. The obvious interpretation is that the value of the dollar is driving oil prices. That said, another way to look at this, one that is more interesting and perhaps more fiscally frightening (assuming you're American) is to flip the causation and hypothesize that the value of the dollar itself is being driven by the price of oil.

Consider, the United States of America runs on oil. No single thing (I'd use the word "factor" but it didn't seem broad enough) affects the overall state of the American economy as does the price of oil. Every facet of our commerce, from personal transportation, to air travel, shipping, manufacturing, even the generation of electricity, all of it relies on Texas Tea. Now, assume for a moment that as other economies begin to emerge, creating their own demand for oil and thus disrupting what was previously a largely two-way trade channel (dollars go to the middle east, oil comes to the land of the free), the value of oil as a commodity begins to have an effect on the very means by which it is purchased.

Take an extreme example: suppose Saudi Arabia, impressed with the continued strength of the Indian Rupee and betting that strength will continue, agrees to sell oil to India (that is, directly and not through an American exchange) at a price of Rs 2500/Barrel (2500 Rupees per Barrel). This would fundamentally set the Dollar/Rupee exchange rate, as 2500 Rupees is now the true value of a barrel of oil, whatever it may cost on the NYMEX. (For those of you keeping score, if oil were $75 a barrel, this would mean the USD/INR exchange rate would fall to Rs 33.33 per dollar. As of this writing, that's about a 28% decrease from today's exchange rate of Rs ~46.25 per dollar.)

I called the above example extreme for a reason; it is. More likely than not, in today's economy such a sale would have a more immediate effect on the commodity markets than the currency, but the point is valid. As nations other than the United States become more involved in the global oil trade, the repercussions of such trade can only have a more profound effect on the value of the currency in which oil is priced. And that would be the dollar. Since the dollar's value is unfixed, the more oil becomes the basis of world commerce, the more the dollar's value relies on how much oil it can purchase.

I wouldn't be at all surprised, one day soon, to hear a loud, southern congressmen proclaim to a captivated populace that we "shall not crucify mankind upon a cross of oil."

I don't know, maybe the metaphor doesn't work as well with a liquid.

*I chose Swiss Francs because of the currency's relative stability. If I had chosen another currency, say, British Pounds, that country's own financial turmoil would have had a more dramatic effect on the quote given and would have been less reliable as a proxy for the Dollar's value. In other words, the Swiss Franc, in my mind, is the best benchmark for a currency's true value, as the geopolitical fallout of some other country is relatively minimized by the Swissie's historic stability.