The Dollar In FOREX Markets

The paper currencies of all countries fluctuate in exchange rate for several reasons, mostly (but not always) due to government policies.

The exchange rate for the Euro (since 1999 when the Euro was introduced) vs the US Dollar, started around $1.18, dropped to $0.83 in 2001, jumped up to $1.60 in 2008, and now is back just below where it started, today at $1.1275 per Euro.

The Dollar today is getting “stronger” against all other world currencies, To see if the Dollar’s strength will continue, let’s look at some causes.

Trade Deficits

Nations trade with each other. If the value of all the goods and services exchanged does not balance, then one country runs a Trade (or Balance of Payments Deficit, while the other runs a Surplus. If a country consistently runs a Trade Deficit, then its currency will pile up in the other country.

The US has run an international Balance of Payments Deficit almost every year since around 1976. The total Deficit – the number of paper Dollars that foreigners have accumulated over all these Deficit years – is around $5 Trillion.

As the Deficit country continues to run in the red, other countries become less willing to hold their paper currency. Their selling in foreign exchange markets pushes the currency of the offender downward in value. So, the accumulated Deficit, and the expectation of future Deficits, are factors helping to determine the exchange rate.

Economic Growth

As the Surplus country builds up foreign currencies, what can they do with them? They can sell them, as noted above, making the exchange rate change. Or, they can invest the money.

A growing Economy will present more, and better, opportunities to make the value grow. Conversely, an Economy in decline will present fewer (or zero) good investment opportunities. If the Surplus country sees a growing Economy in the Deficit country, it will be more willing to hold the paper as its investment grows.

Interest Rates affect the return on investments. Low rates generally reduce the expected return on investment, while a high rate can offer a good return. Additionally, falling rates – since they “stimulate” growth and also offer capital gains opportunities – make investment more attractive, while rising rates make them less desirable.

Inflation Expectations

The value of any investment depends not only on the rate received, but also on what the money will buy later on. Any investor must adjust the expected return to allow for any expected decrease in the purchasing power of the currency – it must be reduced to allow for inflation.

If the Surplus country expects that the debtor country will have a high or rising Inflation Rate, possible investment returns are worth less, decreasing the willingness of that country to continue holding that country’s paper. If the expected inflation rate is low or falling, that would be a plus for the investor.

Future World Trade

If a Surplus country expects its partner to continue running Trade Deficits – if it will send in more and more of its paper currency – the Surplus country might say, “When do I receive more than just promises to pay?!”

The expectation of future Trade Deficits will discourage the Surplus country from adding to its hoard, and might even encourage it to stop investing and start selling.

External Factors

So far, all these things – Economic growth, interest rates, expected future inflation, and future Trade Balance – are affected largely by government policy in the Deficit country. Sometimes, there are factors beyond their control.

Although the Deficit country continues to have poor Economic choices made by its leaders, sometimes another country’s government may become “an uglier pig.” After a generation of poor Economic growth, ultra-low interest rates, and massive Trade Deficits, the US and its Dollar suddenly looks less bad compared to other currencies.

The Swiss halted their Euro peg (effectively leaving the Euro), Greece looks set to leave after this weekend’s election, and Germany (and the northern tier) also have reason to leave. The European Central Bank just announced a massive QE, so there is an expectation of rising inflation, and their Economies are going from bad to worse, especially in light of Russia’s cutoff of natural gas to southern Europe. Japan is an Economic basket case, and Abenomics is making things worse.

Another recent example is the plunge in world oil prices. The US, even with the shale oil revolution, still imports about 2.7 Billion barrels of oil each year (down 1 Billion from 9 years ago). Oil prices falling in half means that the current Trade Deficit of around $40 Billion a month should fall quickly to around $26 Billion!

Now, all these factors can, and do, change. As the US Dollar exchange rate goes up, imports will look cheaper, giving domestic suppliers more competition. And exports will be more expensive, so overseas sales likely will decrease. And with the lower oil price, shale oil production will decrease somewhat, requiring a larger share of imported oil at somewhat higher prices. All three of these mean a return to larger Trade Deficits within a couple of years.

While the Eurozone may blow up this year, the FED can’t raise interest rates in the US because of the massive and growing National Debt. The higher Dollar will mean slower growth – or another official Recession – and the imminent big fall in the US stock markets also will make foreign investment in Dollar denominated securities less appealing.

China, Russia, and several other countries have been accumulating Gold, while Dollar denominated world trade continues to fall, raising the very real possibility that the US Dollar’s role as World Reserve Currency will end in favor of a new Gold-backed currency – or Gold itself.

I expect that the US Dollar may continue rising for another six months, followed by a turnaround, with the Dollar falling to new lows within 3-5 years.

The markets should continue to be interesting to watch.