This article was last updated on May 26
Despite global economic woes, one positive aspect for main street America has been the relatively rapid rise of the US dollar of late. The dollar index (DXY), a measure of the greenback against a trade-weighted basket of six major currencies, has strengthened by over 20% in this time. However, the question is will this trend continue? To answer this, one must look at the current factors driving the US dollar.
Why the dollar is rising
A number of analysts had predicted the continued demise of the US dollar thanks to the financial-sector bailout and weakening economy but its sharp upside has surprised many. The dollar’s recent climb is part of a massive reversal of long-standing investing trends (due to the global economic slowdown) such as buying emerging-market stocks or wagering on rising commodity prices. When investors retreat from such investments, they are often selling them in exchange for US dollars. The U.S. currency remains the most popular among global institutions, accounting for 55% of the assets and liabilities they hold in foreign currencies, according to the Bank for International Settlements. It has been further boosted because banks around the world are scrambling for dollars after inter-bank borrowing between banks all but ceased to function during the past month thanks to the liquidity crunch
After sending money overseas for years, U.S. investors now are bringing it home in a flight to safety. In July and August, the latest months for which Treasury Department data are available, U.S. investors sold $57 billion more in foreign stocks and bonds than they bought — the largest-ever such repatriation. Dollar demand has also been reflected in the rise in purchases (and hence the price) of U.S. Treasury bonds, seen as the safest haven of all. The most recent data shows that such holdings of Treasury’s increased by about $100 billion over the past four weeks. Other countries are also feeling the effects (even more than the US) and so are slashing interest rates to try and boost domestic economic activity, so the expected yield differential with the US is falling. With this trend set to continue, investors will continue to flock to the dollar.
The US economy is likely to recover faster than other economies because unlike other central banks, the Fed more than a year ago began lowering interest rates, which punished the dollar. Now it could be a positive, as other central banks catch up. In the U.S., “a lot of the heavy lifting has already been put in the pipeline,” says Stephen Jen, global head of currency strategy at Morgan Stanley, in the WSJ. “The same cannot be said of Europe.” The same old reasoning still applies: The U.S. is regarded as being able to weather a recession much better than the euro zone
As the dollar rises, US consumers are seeing some clear benefits which overall should boost spending and assist with getting the nation out the current economic slump. Benefits of the high US dollar to every day consumers include, lower oil and commodity prices, lower inflation (prices) and cheaper travel. It does hurt foreign corporate profits and exporters, but given our economy is 70% consumer driven, I think what helps consumers is much more important right now.
Given the rapid rise in the dollar in synchronization with the escalation of the global financial meltdown and tightening credit markets, it stands to reason that as credit and stock markets stabilize so too will the dollar. This means it will give back some of its gains, but should be able to maintain current levels well into next year. If the government implements much needed long term regulatory reform and adopts a more fiscally conservative policy once the economy has recovered, then there is a chance that the US dollar could maintain its strength for a number of years to come.
What about the Euro?
The US dollar continues to strengthen relative to the 17-member Euro currency, which has been on a downward trend as concerns over European sovereign debt crisis and Greece’s uncertain membership of the Eurozone grows. The Euro fell to as low as $1.24, the weakest since its multi-year low in July 2010 of $1.18 following the first bail-out of Greece.
Other major currencies have also seen significant shifts against the Euro which has declined 2.1% this year against nine developed market counterparts. Along with the greenback, the Yen has risen to 6 month highs against the Euro. This has spurred speculation that the Bank of Japan could look at weakening the Yen again. The Yen has stayed relatively constant against the dollar over the last month, suggesting that most currency moves are driven by Euro weakness.
Most analysts are predicting further falls in the Euro as the credibility of and confidence in policy makers wanes. Some are even suggesting that the Euro could reach parity with the US dollar by the end of summer. However this downward spiral could quickly reverse if there is more certainty and clarity around Greece’s exit. Further, new proposals to move towards a European-wide deposit guarantee system and common bond issuance could provide more relief.