Want to learn something about correlation, also known as correlation coefficient? Conceptually, correlation appears simple and recognizable. When two asset classes trade simultaneously in the same direction, they are in positive correlation. When two asset classes trade simultaneously in opposite directions, they are in negative correlation.

Correlations between asset classes differ constantly. Somewhat like a marriage. You go to bed, and synchronicity is positive (what I’ll call positive correlation). In the morning you wake up asking what happened! You both simultaneously disagree on everything (What I’ll call negative correlation.)

During 2007 and 2008, the U.S. $ suffers burdens against nearly every currency. At the same time, oil costs per barrel increase (Important to point out that the cost-per-barrel is dollar denominated.). When looking at a chart, you will notice that when oil goes up the dollar goes down. When the dollar goes up, the price-per-barrel goes down. We call this negative correlation; in fact, just about perfect negative correlation and this explains the trades back and forth between the dollar and oil.

Your asset allocation model wants as many cross correlated asset classes as possible. When one is up, the other is down.

In 1987 the dollar could buy you 154 yen; today a dollar buys you 117 yen. If you traveled to Japan in 1971, you could have a great time with 358 yen for every dollar.

In 1985, James A. Baker as secretary of Treasury Chief listed, “Item one on (the) agenda was the dollar”. This is the subject of the Appendix attached to Baker’s auto-biography, Work Hard, Study…and Keep Out of Politics

The dollar and trade deficits sent U.S. policy makers toward isolation to protect the American worker after World War I. Isolationist policies do not work because we live in a global market.

Baker recalls the steps taken as forty-four nations approved the Bretton Woods Agreement (1944). Bretton Woods established the International Monetary Fund and the World Bank. The dollar was benchmarked to gold prices and other currencies were benchmarked to the dollar.

Baker considers Bretton Woods along with “the Fed’s successful war on inflation” as the fuel that “set the American economy afire.” As with America; so with the world.

James Baker asserts “economic policy coordination” as fundamental for American and international prosperity. After World War II, the United States presumed economic, political, and military supremacy. But the world is changing; some countries do not care what we think or do.

Today, the U.S. is challenged in every category by every nation. Why live the American dream when you can experience the dreams of India, China, or Thailand?

America faces incredible economic challenges. How can we sustain predictable economic power if we do not bring debt under control? Debt payments could become the life-style waster for successive generations.

Well, how does this effect the dollar? One tool countries use for economic management is raising the value of their currency. Currency value is a benefit. Trade balance is the goal.

U.S. economic policy may be in the cross-hairs of low interest rates, low dollar-values, high oil prices (current low-prices are temporary), and large trade-deficits. A decision to control one could be a catalyst for the other.

“History teaches us that men and nations behave wisely once they have exhausted all other alternatives.” – Abba Eban

During an interview on Meet the Press (October 18, 1987), James Baker was prompted to say, “We will not sit back in this country and watch surplus countries jack up interest rates and squeeze growth worldwide on the expectation that the United States somehow will follow by raising interest rates.” (Listen to Bloomberg TV, and you might hear this recurrent economic theme.)

Baker writes, “One lesson I learned at Treasury is that even the most innocent remarks about the dollar or other economic issues could provoke investors to buy or sell, almost blindly, in response.” It all adds up to historical redundancy; the crisp dollar is crumpled.

Greenheads bite. They move slowly, land on your wrist or ankle, and bite morsels of flesh. You can whack them easily; their lumbering weight limits their speed.

Greenbacks move slowly too; they land on your international portfolio, and bite morsels out of your profits. You can’t whack them too easily; their lumbering weight makes them a necessity. Their influence on your portfolio and the US economy is obvious, but what does it mean?

Interest rate increases should prod the dollar’s value higher. Multinational company stocks should offer a haven when interest rates go up overseas when the currency is converted to dollars. As the Wall Street Journal points out (August 14, 2006), this has not worked for the past 14 years. Large cap (capital = stock price times the number of shares outstanding) stocks move in an opposite correlation to the dollar; the two asset classes trade in opposition to each other (when one is up, the other is down).

Now, according to Mike Thompson (Research Director, Thompson Financial), the two asset classes trade “in the same direction”. Thompson attributes this to the US economic shift toward a service economy from a product economy. Manufacturing economies send and obtain “goods wherever they are priced most favorably in terms of local currency.”

As a result, many money managers look for international companies that manufacture and distributed products within their own region or country. Not everyone agrees with this strategy since it ostensibly “gives up” on US multinationals.

If you want a strong dollar, cheer on Mr. Bernanke and his colleagues to push rates up further. This strategy may work for the dollar, but won’t do much for your variable rate mortgage.

Read some of my other articles found as Ethos Musings