Tuesday, October 21, 2008

Why is Dollar Stronger?

Readers Question: I’m just curious about how and why the dollar has strengthened (at least against the Euro and Pound) and why the US would benefit from a stronger USD.

Quite a few people have been asking me why the dollar has been stronger in the past few months. The last time I wrote why the dollar was stronger, it promptly fell by 5%, so let's see what happens this week. :)

USD to Euro Exchange Rate
  • US Dollar to Euro. The US Dollar has appreciated from US $1.6 to 1 Euro to US $ 1.32 Euros.
  • Against the £ the Dollar has appreciated from US $ 2.0 to £1 to US $ 1.74.
This appreciation of the dollar doesn't represent a changing of the fortunes of the US economy. Economic fundamentals still point to a weak dollar.
  1. Current Account deficit
  2. Slowing economy and prospects of even lower US deficit.
  3. Growing National Debt, which could lead to inflationary pressure.
  4. US relies on foreign countries to buy about 25% of its National debt. This makes the US vulnerable to China and Japan withdrawing their demand for dollars.
See: Why US Dollar is falling. Although written over a year ago, it is still relevant today.
The real worry is that the US becomes so indebted the Federal reserve start to default on the US National Debt, this would cause a run on the dollar. See: Will the US Dollar Collapse

So Why is the Dollar Stronger?

There is a pretty convincing case to say the dollar should be falling. But
  1. The dollar has been in along bear market. In the beginning of 2002, the exchange rate was US $ 0.9 / 1 Euro.
  1. The recent strength of the dollar should be placed in a longer context. Yes, it has appreciated a little, but, over the past few years, it is has still fallen in value.
  2. The Euro and UK economy have deteriorated sharply in the past few months. The strength of the dollar really means the weakness of the UK and Euro economy. The US was the first economy to experience an economic downturn. But, the UK and Euro economies have faced a sharp slowdown in the past few months. This has led to interest rate cuts in UK and Europe. Also investors expect further interest rate cuts in Eurozone and UK because of the impending recession. Interest rates are currently higher in Europe than US, but, people expect European interest rates to fall.
  3. Purchasing power parity. The US dollar is cheap on purchasing power parity. Europeans going to America find goods to be very cheap.
  4. Hedge Funds. Problems in emerging markets are encouraging people to withdraw assets from these countries. Therefore, as these are being sold people are exchanging them for dollars.
Is Stronger Dollar A Good Thing?

A strong dollar makes imports cheaper. It reduces inflation and it leads to higher living standards. But, a strong dollar causes less exports. A strong dollar is good during a boom, but, in a recession it can cause slower growth.

Is A Strong Dollar a Good thing?


Anonymous said...

Great - Thank you so much sir! That answers just about every lingering question :)

Anonymous said...

Good article and I agree with the longer term view of a weaker dollar. As I wrote recently, the rapid rise of the US dollar in the near term is a result of the flight to safety to US treasury's due to the global financial meltdown. This just shows despite America's longer term challenges it is still viewed as the financial bastion of the world. Hard to believe with the all the institutional collpases, but in Red, White and Blue we trust.