Tuesday, October 28, 2008

Why the US dollar is rising so fast

Despite global economic woes, the US dollar has been on tear over the last month resulting in a 25% plus appreciation against the Australian Dollar. 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

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.


From an Australian perspective there are benefits and drawbacks from a higher or lower US dollar depending on your perspective. However the most important thing for the global and hence Australian economy is a stable US dollar which implies a stable economy. So in the short to medium term the focus should not be on the daily currency moves but rather on the range of the moves.

***************************************************************
Liked this article? Then consider subscribing by
clicking here to receive regular updates
***************************************************************