The $USD on Steroids

pile of us dollarsWhy is the US dollar so strong these days, and what is the significance? Well, unless you’ve been reading financial news, traveling, living outside of the United States, or really paying strict attention to the cost of all the imported goods you buy, perhaps you haven’t even realized that the $USD has been on a tear in forex markets. But, I’m guessing a good number of you have noticed or have an inkling at least that the currency these days has been bulking up considerably. What’s going on? Is it a new trainer? Mega amounts of egg protein and creatine? Performance-enhancing drugs? The answer lies somewhere between central bank actions and investor sentiment.

We must recall that the value of any fiat currency (paper money) in forex markets is first and foremost comparative, that is it is measured against other currencies to determine its value. Put another way, the value of a dollar is a factor of the value of another currency or basket of currencies. The Federal Reserve, for instance, can take steps to try and strengthen or weaken the dollar vis-a-vis other currencies, depending on the objective at hand, but then the central banks of other countries can do likewise with their own. If the Fed takes steps to strengthen the dollar while others do nothing or take measures to weaken their currencies, well, then, the dollar will indeed strengthen against those other currencies.

Similarly, if the Fed does nothing while the currencies of other countries are intentionally or unintentionally weakened, the dollar will gain in value once more. When a dollar is strong against another currency, a dollar can buy more of that other currency. Conversely, one unit of that other currency now buys less dollars than before. Take the case of Canada, for instance. For many years it rose in value against the dollar until it reached parity, or 1-to-1 value, and then even eclipsed the dollar in value – consequently many Canadians living along the border with the US would cross that border to go shopping for clothing and the like; in effect, they were using Canadian dollars to buy US dollars (more than they could before) to then buy the items being sold in the US. To an American in 2007, a shirt at an outlet store might still cost $20 USD, but to a Canadian, it was closer to $18 USD. However, since 2013 especially, the $CAD has been losing value against the $USD (or the $USD has been gaining value against the $CAD, however you want to look at it), now making it more appealing for Americans to cross into Canada to do the same. The following chart shows the value of the $CAD against the $USD over the last 10 years.

CAD/USD chart 10 years

The $CAD against the $USD over a 10-year period through August, 2015

With all this in mind, the dollar has been gaining in value for a host of reasons, not the least of which is the purposeful attempt by other countries to devalue their currencies. Many countries, from Canada to Switzerland to China, have been cutting their interest rates in an effort to make their currencies, and consequently their goods, cheaper to buy. As the Fed has neither raised nor lowered rates in some time, the dollar becomes more expensive to buy for others – it gains in value against these currencies. By lowering interest rates, central banks make their currencies less desirable from an investment perspective. Savers will have a hard time justifying saving their money because they won’t earn much of a return with a savings account, CD, or bond, and may just spend their money instead. Outside investors will realize more or less the same – the return on an investment in such-and-such country has been lowered, I’ll invest elsewhere. At the same time, they encourage other nations to buy their goods and services or invest in factories or service centers or the like, ideally boosting their economies. If it sounds paradoxical, it is – there’s always a balancing act in play.

Additionally, countries have been devaluing currencies by expanding their money supplies or increasing incentives for banks to make even more loans, which signals to their local markets that, with an increased supply, each individual unit of currency is worth a bit less now – each unit isn’t as special anymore, and anything that’s easy to get tends to cost less. Hence, the currency should be spent, not saved.

Another factor is the winding down of risky investments. By some accounts, investment with $USD in emerging market countries was quite high from 2010 to 2013, but now as people become ever more concerned with the ability of the largest economies in the world to consume the goods of the ones growing the most, investments have been sold and foreign currencies converted back into dollars. That increased demand for dollars again (and decreased demand for that other currency, whatever it may be), just like increased demand in an auction for some painting, drives the value of the dollar back up versus that other currency. Countries with commodity-based economies have been especially hard hit.

What’s more, given the shakiness of the global economy and the volatility in various markets in which one can invest, some investors are not reinvesting those dollars, they are sitting on them for the time being until the picture becomes a bit clearer. By not spending them, the value of the dollar increases because some of the available supply is being withheld. Along the same lines, with numerous countries experiencing sovereign debt crises, other countries experiencing inflation, shortages, and worsening economies, and yet others indicating to the world that they are not the growth powerhouses they once were and that there are internal issues to be concerned about, there is a flight to safety to US treasuries and dollars by many all over the world. Just as with a high demand for oil, the price goes up, so a high demand for dollars or dollar-denominated investments causes the dollar to gain value.

Lastly but not exhaustively, the Fed may raise interest rates later this month. While they may not raise them considerably or at all, just the possibility puts a damper on the spending of dollars. Higher interest rates change the debt payments people, companies, and foreign countries make, they change derivatives contracts and payments on those contracts that mega banks and numerous counterparties have co-signed on, they reign in financial investment speculation, they act to cool an economy by potentially slowing investment in things like housing and factories, they make saving more appealing (albeit ever so slightly in this case). Because we don’t know whether the Fed will in fact go through with an interest rate hike or not, this uncertainty has the same effect. Perhaps, that’s even what the Fed wants.

If the Fed were to raise rates, it would also signal the beginning of a process of raising rates moving forward, a shift from an accommodative monetary policy to a tightening monetary policy, a future which is different from the last several years since the DOW bottomed in March of 2009. It behooves anyone with plans to invest a great amount of capital in anything to wait to see what decision is reached because so many things can change and for some the results could be quite painful, if not disastrous. This holding pattern causes the dollar to gain against other currencies, and a decision by the Fed to raise rates would make the dollar even stronger.

“Why would they do that,” you might wonder. After all a strong dollar hurts any American employer that exports goods to other countries and hurts countries with debt denominated in dollars, potentially setting off a destabilizing, cascading effect for the debtors and the creditors. The Fed is caught between an improving economy and a hard place. Their first responsibility is to the United States economy to keep growth moving along but avoid nasty things like inflation. The consequences that their actions have elsewhere in the world is secondary to this principal responsibility and you can never please everyone. It’s not an enviable policy decision the Fed is on the cusp of having to make moving forward, to say the least.