Monday, September 15, 2008

Why is US dollar Appreciating?

In the past 2 months, the US dollar has staged a strong rally.
  • For example, in July 1 Australian dollar was worth $0.98 US. By, August 30, this had fallen to 0.78 - quite a marked fall.
  • In July 1 US $ was worth 0.62 Euros. By Sept 10 this this had risen to 0.71 Euros.
  • In July 1 US $ was worth £0.5 By September 11th this had risen to £0.57
Why has the dollar appreciated? and is the appreciation temporary or permanent?

Firstly, the US economy is weak.
  • Growth is slowing down (annual growth rate of around 1.3%)
  • Interest rates are very low (2%)
  • Unemployment is rising
  • Current account deficit is still a high % of GDP (despite recent improvements)
  • Concerns over Financial system, highlighted by the failure of major banks
From a textbook analysis, America has all the ingredients of a weak currency.

The main reason for the dollar's appreciation is the realisation that maybe the dollar has been oversold in its long bear market since 2001.

The other important reason is that there is a growing awareness the economic troubles which began in the US, have spread to the rest of the world. In fact, it appears that the Eurozone will be the first to enter an 'official recession'.

The dollar's recent strength is therefore not a thumbs up the underlying economic conditions of the US, but, a reflection of the European slowdown. (see: Euro economy first into recession)

With US interest rates at 2%, there is little further that they can fall (especially with inflation nudging towards 5%). However, in the Eurozone, interest rates are more than double that in US. The slowdown in the Euro economy has been quite marked and it raises the real possibility of lower rates in Europe. It is these lower interest rates in the UK and Europe that will reduce demand for the dollar.

Prospects for US Dollar in 2009

The US, has so far avoided an official recession (helped in part by a weak dollar, which has boosted exports). However, the credit crunch shows no signs of reaching the bottom. 2009, is likely to bring more bad news for the economy. How many banks will need rescuing like Freddie Mac and Fannie Mae? The economy will slowdown further in 2009, and this will make the dollar weaker.

However, with a global slowdown, the US dollar will not be much weaker than other currencies.

This short term appreciation in the dollar does not reflect a return to a strong dollar. This will only come if the US can overcome fundamental problems such as:
  • Structural current account deficit
  • Unbalanced economy - high debt both private and public
  • Problems in Financial sector. How many more banks will go under? Can the financial system cope?


Anonymous said...

For me the only logical reason is because many US companies pull out their investment from all over the world. They changed their investment in local currency into US Dollar and send it back to US. We can see in every country US companies are hunting for Dollar. Due to this increasing demand, the dollar is appreciating.

barrymat2 said...

How much of it is due to the need of the US govt
To sell US$ bonds overseas to cover this mess

Tejvan Pettinger said...

They have already been selling a lot of debt to foreigners. Therefore, this doesn't explain the recent increase. In fact they may struggle to attract foreigners to buy debt and foreigners could start selling the US debt they own - this would cause a fall in value of dollar.

Anonymous makes a good point about US companies pulling out investment from oversees.

Anonymous said...

To be honest, the simple answer is that consumers aren't spending, they are saving. Fewer dollars floating around means supply goes down and the "price" of a dollar goes up.

royal said...

how soon do you think the dollar will start depreciating again,i.e become surplus in the market

Nick said...

As soon as I sell my gold!