Declining the Dollar
Kurt Brouwer July 15th, 2008
One great thing about the financial markets is that they force us to evaluate trends objectively. The declining dollar is a case in point. It is clear that the dollar is falling against major currencies. That is undeniable. And, from a financial perspective, the declining dollar is neither good nor bad, because all trends have winners and losers.
When the dollar falls against the euro or the British pound or the Japanese yen, investors in those currencies or stocks or bonds denominated in those currencies will gain. And, U.S. companies that export goods will find their products are more competively-priced against rival products sold in the hot currencies. On the other hand, if you’re buying something that is imported or going on a vacation in London, well…that outrageously-priced cup of coffee just got more expensive.
Why is the dollar falling? There are many theories, but the most obvious one is short-term interest rates. Short-term rates are going up overseas and they’re not going up here, so very large institutional investors such as big banks, securities firms, central banks and so on are moving cash to other currencies. This is normal and not particularly significant. However, if the dollar kept falling, there is a point at which the U.S. Treasury and the Federal Reserve would have to take some steps to bolster the dollar. We are not at that point yet, in my opinion, but we should be. I think the Treasury and the Fed should begin working with other central banks in order to stabilize the dollar, which has fallen steadily versus the Euro. This chart shows how many dollars it takes to buy one Euro. The Euro fell for several years versus the dollar and begin moving up in late 2001:
Source: St. Louis Federal Reserve Bank
David Gaffen at the Wall Street Journal’s MarketBeat Blog (daily reading for me by the way) gives a bit of background on why the mood seems so dour right now [emphasis in the original]:
Pity the Dollar (WSJ/MarketBeat Blog, July 15, 2008, David Gaffen)
…The U.S. currency hit a new record low against the euro Tuesday, three-month lows against the British pound and is nearly at parity with the Australian dollar, of all things, as global investors question the value of U.S. assets and the quality of the entire U.S. balance sheet, so to speak.
“Markets are fearing another major crisis, and they’re doubting that the Fed or U.S. Treasury will do anything near-term to alleviate the situation,” says Kathy Lien, chief strategist at DailyFX.com. “They’re skeptical about the efforts of the government.”
Of late, the euro traded at $1.5969, down from a record of $1.6038 reached earlier in the day. Global markets dropped sharply in the wake of the middling showing by U.S. markets Monday after a Fannie Mae/Freddie Mac rescue was announced.
…The dollar has continued to come under pressure as investors believe U.S. assets do not offer enough return for the risks being taken. Bond yields are low when compared with other major global economies, and the Fed is in a bind – it cannot raise rates while the economic malaise continues, but it fears worsening inflation if it lowers rates.
“The deteriorating market and economic conditions in the U.S. continue to be the chief causes of the broad decline in the U.S. currency,” writes Ashraf Laidi, chief currency strategist at CMC Markets. “As long as these continue, the dollar will deteriorate regardless of any jawboning by policy makers, which would be perceived as bluffing rather than communicating real policy intentions.”
…In part, the dollar’s decline mirrors the fall in U.S. equities, which are reacting to Mr. Bernanke’s testimony. “What’s basically happening at the moment is that the dollar is following equity markets, and they’re going down, and the reason it’s all happening is the credit crunch which is based in the States,” says Chris Furness, head of currency strategy at 4Cast Ltd.
Yesterday, we reported that PIMCO and Bill Gross had turned positive on the dollar vs. the Euro (see Gross Likes Dollar vs. Euro For First Time). Obviously, the brain trust at PIMCO is responding to broad economic and financial trends so this should not be taken as a sign that the dollar will turn around right away. However, it is positive in that the folks at PIMCO believe that the Euro is overvalued.
In order for the turnaround to begin though, I believe the Fed and other central bankers are going to have to give the currency markets a strong signal that they are supporting the dollar. See also How Far Has the Dollar Fallen? And Why? — What’s Next?.
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