Why is the greenback so powerful?
The currency of a nation is a key indicator of the economy’s performance. A well-developed economy with a robust foundation will attract foreign investments due to the perceived safety and the ability to acquire a reasonably high return on investment. Investors across the financial spectrum would want to yield the highest returns that are predictable or ‘safe’ from abroad. Since the dollar has gained its reputation for the same, everyone wants a piece of the pie, and hence the country has seen a strong capital account for the dollar. However, the average American consumption would also have imported goods and services leading to an outflow of the dollar to, resulting in a deficit in the current account. However, having a strong economy, a country can attract foreign capital to offset the trade deficit. That allows the US to continue the role as the consumption engine that fuels all the world economies, even though it’s a debtor nation that borrows money to consume. This allows other countries to export to the US and keep their own economies growing.
Alright so how do traders determine a direction or trend of the value of the dollar? From a currency trading standpoint, they look at the supply Vs demand of the Dollar, sentiment and market psychology and technical factors, all tied up with analyzing the current geopolitical risks associated with current market trends.
Supply Vs Demand for driving dollar value: Businesses in the US that are largely into exporting goods and services creates a demand for dollars as customers which increases the demand for dollars relative to other world currencies. Further, in the corporate side when large corporations raise funds through a combination of bonds and equities, a foreign investor would have to sell their currency to buy these dollar denominated assets. All these instances show that as demand increases with no substantial increase in supply, the value of the dollar increases.
Economic Sentiment: Even though US is considered a safe haven for investors during time of uncertainty, as the economy weakens and consumptions along with employment takes a hit, the economy would be confronted with a possibility of a sell off in the bond or equity markets. This would result in foreign investors looking to their local currency and thus leading to a fall in the value of the dollar due to an increase in supply. In addition to the payroll data, GDP/Debt ratios and unemployment rates, analysts must look at the big players leading the economy i.e. the investment banks and asset management firms to actively gauge economic market sentiment.
The best indicator of how the dollar is fairing is the Dollar Index (DXY)- It represents the performance of the dollar with respect to six major world currencies which include the Euro, Japanese Yuan, Canadian Dollar, British Pound, Swedish Krona, and the Swiss Franc.
For example, the famous global financial crisis had put a stop to the powerful dollar at the time. The role of the Fed at the time of the 2007 crisis was unprecedented. Large deleveraging of financial assets, and high default rates created chaos amidst an ever growing US economy, therefore, the central bank and the government had to take up the slack by injecting cash into the market so that consumption and employment rates would return to pre-crisis levels. This came with the expense of a massive deficit and debt, which then resulted in the fall in the value of the dollar. The DXY indicated an all time low of 71.60 on April 22nd, 2008 due to a major sell off in the equity and bond market, along with the Fed slashing interest rates so that investors and household can avail cheap credit. Then started the process of Quantitative Easing which led to the 26.18% drop in the US Dollar value compared to pre-crisis levels. As the Fed continued its expansive monetary policy to improve conditions of the economy, we started seeing the value of the dollar go up only 2011 onwards. Fast forward to 2014-16, we saw a 21% in the jump in the DXY Index. This increase was the result of the Fed tapering off its Quantitative Easing program and raising interest rates. This constrained the supply of the dollar which had the effect of increasing its value.
Looking into the worst crisis the world has faced since WWII, with unemployment rates at 13.3% and economic growth rate of -4.8% in Q1 and a forecast of -25.3% in Q2, you’d expect that the value of the dollar to fall drastically, but US Dollar is still King as coronavirus slams the country. The 6% rise since its lowest point in March is primarily due to the dollars privileged position as the world’s reserve currency (more on this later). That’s a clear indicator for investors to put their money in the dollar in times of a crisis and even if the US economy is in trouble as well. This is primarily due to the fact that the US is considered largely politically and economically stable which shows that the dollar’s value is not going to drastically fluctuate the way the Turkish Lira or the Argentinian Peso have in the past. Further, the US dollar has more than $1.8 Trillion in circulation around the world, with more than 2/3rds of $100 bills and half of $50 bills held beyond the borders of the States. The currency has not weakened even with the Fed’s move to pump in trillions of dollars in liquidity into the financial system because the greenback is the most currency traded in the world on the foreign exchange market. Furthermore, the Fed has started to facilitate currency swaps with several other central banks to increase their dollar reserve which has led to massive surge in demand. The trust and global confidence that the dollar has won over the past years despite trillions of dollars in debt and continuous large deficit spending has contributed to its climb to be the top global currency in the years to come. However, with tensions brewing with China, the dollar’s number one status is under contention. Countries feel a new one world currency, not backed up by any one nation will be conducive for the way forward.
By Aman Advani - BSc. Economics at The University of Warwick
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