Stronger Dollar? What It Means to the Average Consumer

As measured by six major currencies, the US dollar has appreciated 19% during the past three months (August to October 2008). To be specific, the US dollar index is now at 85 up from the low of 71.3. The reversal takes the valuation of the US dollar back to October 2006 levels. It just experienced its best week of appreciation in almost 16 years. By any measure, the stronger dollar was unexpected by the financial market in terms of its speed, timing, and magnitude.

Typically, a strong currency should be the sign of the strong economy. However, everyone knows that America’s biggest financial institutions today are insolvent and some had even filed for bankruptcy. The government is also spending millions to “bail-out” everything from banks to insurance companies to auto manufacturers. If that’s not enough, the value of commercial real estate is sinking together with residential real estate.

Consumer spending is drying up, the credit crunch is affecting the market, and the global economy is on the verge of stalling. In this negative economic backdrop, why is the US dollar getting stronger?  

Fundamental Reasons

The seven-year decrease on the dollar’s value until July 2008 has improved the United State’s competitiveness in the world market. Ever since the effects of the J-curve dissipated, increasing export revenues was experienced. At the same time, slow GDP growth has also allowed imports to decline. The two factors stabilized the US trade deficit and it allowed net experts to add 1.1% to the third quarter 2008 GDP growth. Another effect of the decreasing US trade deficit is the narrowing current account deficit. By driving fewer dollars to foreign suppliers, global liquidity shrunk and it further supported the dollar.

Another fundamental reason why the US dollar experienced appreciation is the improving US terms-of-trade ratio. The United States is an energy importer and this expenditure represents a large chunk of its total import cost. Declines in crude oil prices have benefited the United States with regards to its terms-of-trade; the net effect of this also supported the dollar.

Lastly, investors believe that the United States will experience deflation as opposed to inflation by looking at its negative break-even yields for inflation-linked bonds. The expectations for declining price levels also create the expectations of currency appreciation. When the currency depreciates in real terms, there is a likelihood that it will appreciate for nominal terms to compensate for price-driven depreciation.  

Technical Reasons

Perhaps the largest driver for the dollar’s appreciation is the meltdown of prices in the commodity market. The dropping energy prices have had a very strong effect for the currency’s appreciation. While most commodity consumers are cash buyers, there are others that invest in commodities as an asset class. They typically fund their positions using the US dollar which puts the US dollar in “short position”.

As these commodity carry trades are being unwound today, it worsens the weakness of the commodity market and contributes to the strength of the US dollar. In addition, US investments offshore were un-hedged and most of these monies are now being repatriated.  

The “Strong-Dollar” Policy

For years, the Department of Treasury and the Federal Reserve has supported a “strong-dollar” policy. It didn’t work. In the last seven years, the value of the dollar has deteriorated rapidly against the pound, the euro, and other major currencies. If not for government intervention on the dollar, its value would be decreased further a long time ago. Now though, it appears that its value is bouncing back. The question in every consumer’s mind is whether this is good thing or not.

On the surface, it would appear that having a strong dollar is a positive economic development. But before reaching this conclusion, it is important to take note that when currencies fall drastically, it reaches a point when there are no longer any sellers. At this stage, the currency value can “bounce”. After the US experienced significant downturn in the last two years, investors might have concluded that the dollar has reached its lowest point. Weaker currencies are now under scrutiny.

It has become evident that the economies of developing countries may fall apart faster than that of the United States. This conclusion led to the collapse of “carry trade”; the carry trade is the method wherein investors borrow in weak currencies such as the US dollar or the Japanese yen and invest it in high yielding currencies.

Carry trades have been profitable when the dollar and the yen tumbled in the past. However, some emerging markets are now apparently on the verge of collapse and investors are moving their investments from won, pesos, reals, and forints back into the US dollar. As sell their foreign currencies and convert it back into dollars, the demand is driven up allowing the dollar’s value to appreciate.

Another factor that drives up the value of the currency is the plummeting investment market. People are dumping their stocks and commodities but their money has to be placed elsewhere. By default, the dollar gains from the meltdown. The worldwide banking crisis has also contributed to the soaring dollar value. People try to get as much hard currency as possible as banks cut their credit lines and decrease their lending.

All the above mentioned factors have created an environment where the dollar can thrive temporarily. Essentially, the severity of the financial crisis right now has forced people to turn to the most liquid asset available in the market: the US dollar. This is in spite of the country’s compromised economic system and financial meltdown. The US dollar easily remains one of the most tradable assets in the world.  

The Risk of a Strong US Dollar

Having a strong dollar should be a good thing. However, if it is the result of market panic as compared to strong economic fundamentals, then it places the economy at a vulnerable spot. Adrian Ash, a financial analyst, believes that a strong dollar from market panic is not in the best interest of the US or global economy. The artificially strong US dollar is a recipe for disaster.

A dramatically increasing value of the dollar means that in an instant, the American consumer can buy foreign goods and service on the cheap. On the other hand, it makes it expensive for foreigners to buy US goods and services. Exporters from the United States will have to deal with a two-sided problem: the slowing economy and unstable exchange rates. Looking at the macroeconomic scale, the trade deficit will spike. Hundreds of billions will leave the country because of outsourcing and trading.

This is a situation that no one in the United States should be glad about. Too many jobs have already been outsourced elsewhere. The unemployment rate in the country, already high, can increase if nothing is done on the situation. What should the United States do then? Historically, every time the country was faced with an economic crisis (ie. September 11 attack, the dot-com bust, etc), the government adopted inflationary policies. It devalues the US currency. 

Today, the government’s incentive to create inflation is greater than ever before. The debts incurred by American consumers during the housing bubble are the greatest in history. In addition, the liabilities of the Social Security, healthcare, and pension plans dwarfs the country’s ability to finance them. The only option left open to the government is to keep the economy functioning properly by paying the bills.  

The Future of the US Dollar

The United States is “bailing-out” struggling organizations and the government plans to jolt the economy back on track with its stimulus plan. But it is also important to determine where this money will come from. The government can get the money from several sources including the Federal Reserve, from abroad, or it can “create it out of thin air”. In any case, the result is almost the same. The economy will be undermined with additional debts and inflationary pressures.

Meanwhile, the Federal Reserve is cutting interest rates to boost the money supply in the market. Rich Yamarone, the economic research director at Argus Research, has said that “rate cuts, fiscal stimulus, and bailouts – they’re throwing everything they can at this right now”. Even a rate cut of almost 0 percent is not out of the question given the desperate situation.

Imagine if a currency can be borrowed at 0%. The main reason why the average consumer cannot borrow at that rate is that everyone will know what a sham the monetary system is. Everyone will borrow if they can get their hands on a 0% loan. If they have the ability to do this, the real value of their currency will be revealed. The value of any money that can be created out of thin air and lent out will always come near to zero.

The strength of the US dollar is temporary. Soon, the money created by the government to bolster the economic system will be hoarded by the struggling financial institutions and this money will make its way to the real economy. Once this happens, high inflation will occur and it will crush the dollar’s purchasing power.

For now, the world will continue to panic its way into dollars, hoarding up the currency, and drive up its value.  But once investors realize the real value of the dollar, they will just as soon panic their way out. 

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