Why is the dollar falling?
i forgot what the cfai said about currency fx but there were 4 factors that influence I’m going to guess at the 4: 1. pricing parity (U.S. wins this compared to other developed countries) 2. interest rates & their movements (U.S. is lowest, thus the loser here, except for japan) 3. fiscal policy (U.s. is the loser here) 4. economic outlook, growth gpd, etc. (U.S. isn’t exactly winning here but for a developed nation is probably doing ok). Pleas correct me if I didn’t get them right. I been drinking 2 buck chuck.
I think virgin hits it on the head.
Uh, forget the CFA for this question. It’s supply and demand, and the dollar is not in demand. Why? There are many reasons, starting with Bretton Woods.
I think that a currency regime that has been dead for 35 years has little to do with our current problems. I also don’t see any reason to disparage the CFA curriculum on this point. But the problems are clearly things like irresponsible fiscal policy, imbalance of trade, too many dollars overseas, rethinking dollar as reserve currency, momentum, and a million other causes.
Wreckless Federal Reserve…no???
The price of a currency is basically how much you pay to get access to the goods, services, and assets of an economy. If demand for a country’s goods and services goes up, the currency goes up - that basically gets reflected in a country’s exports figure. However, if that same country is importing a lot, it means that it will be selling its currency to buy things from elsewhere, and that brings the currency down. So net exports (Dollars of exports - Dollars of Imports) is one of the key figures in currency valuation. For the dollar, US has been importing far more than it exports for some time now, which is driving the dollar down. But it’s not just net exports and demand for goods and services, currency also reflects demand for access to investment in the country, so even if one doesn’t want the goods and services from a country, you might be needing to buy currency because you want to participate in the returns from its stock market, or you like the quality of debt they issue and the interest payments you get from it. Or (in the case of the US), you might like the fact that US Treasuries are considered by many the only truly risk free investment (which isn’t quite true because there is inflation risk and potentially currency risk). All of this drives up demand for the currency. And, like the goods and services argument, if US investors are deciding to send investment money abroad, they will need to sell dollars to do it, and that brings the currency down. So let’s tally up what’s happening with the dollar: 1) US Consumers buying tons of cheap goods from China and other emerging markets, because we can’t make this stuff at home as cheaply. Many of our exports aren’t all that price competitive anymore and don’t make up for the cost of importing stuff from abroad. The dollar goes down (but exports may improve over time because of the weak dollar, which helps correct) 2) Foreign countries like China and Japan had been buying US treasuries as a place to store their reserves; however the low rates of return, concerns about over-concentration, and the rise of sovereign wealth funds mean that demand for treasuries is declining, reducing the need for US currency along with it, because sovereign wealth funds are storing their wealth in places other than US treasuries. 3) The US government has been waging an expensive war in Iraq. This war has been paid for by tax cuts, which means more borrowing. This raises the yield on treasury securities, which normally would make them more attractive, but when the government borrows too much, people start getting worried that it will just start to print money to inflate away its true expenses, and this makes investors nervous. 4) The US economy is in at least a slowdown, probably a recession. This means that stock market returns are not likely to be very attractive, so foreign investors might be putting their money elsewhere, reducing demand for dollars. In addition this suggests that there might be oversupply of goods and services in the US, reducing the price of US exports and therefore the total export figure. 5) The Fed has been cutting interest rates to calm mostly financial market fears and hopefully stave off recession. This makes US Treasury securities less attractive in the short term, although lower real interest rates will tend to make a currency appreciate over time relative to others. It also counteracts some of the concerns about (3), except that it feeds the worry that the US may just inflate away debt. 6) US investors are starting to diversify more internationally, so that dollars are being sold to purchase foreign investment assets. 7) The US looks set for stagflation, which means that financial assets are going to perform very poorly. Eventually, US exports will become cheap enough that the balance of trade will shift around to help strengthen the dollar, but not until a lot of weeping and gnashing of teeth has happened.
Good post Chadwick - the question then is, when does the dollar rebound? Those are some big-time secular themes playing out PS - You think that Treasuries are the only real pure risk-free asset? Come on man, Look at Ambac. I mean, Moody’s gave them a AAA rating. That’s as risk free as a treasury. What? You mean some of these AAA’s are not as risk free as treasuries? huh? Okay then!
Awesome post Chadwick. Anyone want to expand on his 5th point? It seems counterintuitive that lower real interest rates will make a currency appreciate over time. Seems like foreign investors would not invest abroad because of lower fixed income returns. I was thinking maybe lower interest rates provide cheaper capital for companies and increase equity returns. This could persuade foreigners to invest in the US. However, it seems like interest rates are generally low when equity returns are low…
I guess they want to make the whole CFA experience a bit cheaper for us Europeans
apcariso, it is a little counterintuitive that lower real interest rates will make currency appreciate over time. Just remember that the intuitive effect does happen, it’s just a short term immediate effect (that makes currencies fall), but the long term effect is the reverse. To see why, just imagine that real interest rates are at 5% in the US, and 10% in the UK. And let’s suppose that 1 GBP buys 2 USD (so USD/GBP = 2.00). The US has the lower rate, so it’s supposed to appreciate. If you put 200 USD in US treasuries and 100 GBP in UK gilts, then in 1 year, you’ll have 210 USD and 110 GBP. If nothing else changes in the economy, then, it will take 210 USD to buy 110 GBP, which means that USD/GBP = 1.91. So now it takes fewer dollars to buy a pound, the dollar is stronger. Currency math is counterintuitive sometimes because you have to keep track of what’s in the numerator and what’s in the denominator all the time. It gets confusing, which is why it helps to have some of these little principles memorized so that you get early warning when you’ve flipped things around. As for your other point, lower interest rates would provide cheaper capital for investment in technology and things to increase profitability, but those things usually don’t hit the market for a while, so it’s a delayed reaction. (I had an interview for a currency job last summer, so I really boned up on my currency stuff - plus I like global macro thinking, and a lot of global macro bets are really currency bets of one form or another).
Thanks Chadwick… crystal clear.
is lower interest rates cause a currency to appreciate , why was Yen languishing for almost a decade when Japanese interest rates were close to zero ??
it’s not just lower interest rates. I guess no one wants to read what the CFAI says. Instead let’s all just make up a bunch of bs based on our gut feelings about currency. We can contribute it to what the clown show media is saying. Or you can just realize that multiple factors “influence” currency changes. You’re a fool if you think you can slap some sort of fundamental price on a currency like you can a bond.
Definitely agree with virgin on the point that multiple factors affect currency, and you can’t just do a DCF model to figure out what a currency should be valued. As for Japan, Japan suffers from the problem that “0 isn’t low enough” to stimulate economic growth. Japan’s exports aren’t so bad, but the country needs to import tons of stuff, including food and labor for its aging population. So the money supply isn’t growing very fast, but economic output isn’t growing fast either, so whatever benefit comes from low interest rates is demolished by the fact that the rest of the world is growing faster than they are, so PPP is not maintained. This is aggravated by the fact that foreigners borrow Yen at incredibly inexpensive rates and invest it elsewhere (not Japan) for growth. This sucks up the extra Yen into what’s called “the Yen carry trade.” So the Japanese don’t really get much benefit in terms of domestic investment from low rates. Be prepared for the dollar carry trade soon. That’s gonna hurt.
But the Yen carry trade should have increased the demand for Yen leading to an appreciation or some sort of correction . Right ??
CFAdummy Wrote: ------------------------------------------------------- > Why is the dollar falling? Because you touch yourself at night
taz722 Wrote: ------------------------------------------------------- > But the Yen carry trade should have increased the > demand for Yen leading to an appreciation or some > sort of correction . Right ?? They’re not buying Yen, they’re borrowing them, and the first thing they do once they have them is sell them for euros, yuan, or reams or something. That weakens the currency. If they wanted to lend the government money, or lend Japanese companies money, then it would increase demand for Yen. This is the opposite transaction.
great posts here bchadwick, thx