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A few days ago I learned that my good old friend has received an offer to pursue his master's degree in Economics from two of the most prestigious universities in Australia. While I am a bit disappointed that it is highly unlikely for him to study in Canada (since I could visit him in Canada easily), I am also happy that Australia could be his next pit stop because Australia is a wonderful country and my heart has always had a special place for Australia. I still remember some of the lyric of Australian National Anthem "Advance Australian Fair". As we were talking about his degree, I told him that he was very lucky to study in Australia, owing to the fact that as of the late the Aussie dollar is relatively much weaker against the U.S. dollar (USD) which means he could buy more Aussie dollar with his USD. To my surprise, he told me to shut up and confidently said he already know all of the stuffs that I’ve said. The sheer arrogance of this dude who is admitted to the top Australian universities is beyond belief. I also told him that I wouldn’t be able to discuss anything with him related to economics once he completes his PhD. Anyways, all jokes put aside, I think it would be an awesome idea to discuss the causes that leads to a strong dollar, thanks to the brilliant discussion on Australian dollar and USD exchange rate. Let’s get to our main discussion: the causes of a strong dollar.
Introduction
The United States dollar has appreciated gradually against other currencies over the past two years. In fact, the U.S. Dollar Index, which measures the value of the dollar in relative to a number of major currencies from developed market comprising of Euro, Japanese yen, Pound sterling, Canadian dollar, Swedish krona and Swiss franc, has risen around 15 percent since June 2014. The euro was traded at 1.058 dollar as of April 2015, according to Bloomberg’s website. The dollar appreciation has brought legitimate concerns to multinational companies, investors and the international market.
As a result of globalization, the world has become increasingly intertwined and the role of currency exchange rate in promoting economic growth has also been amplified accordingly. The strength of this dominant and international currency known as the U.S. dollar can have broad implications to not only the U.S. market and economy domestically but also the global market.
Causes of a strong dollar
Many currencies of both developed and emerging market have depreciated significantly against the dollar in 2014 which can be attributed to several factors.
The first factor is that the U.S. economy is recovering at a much faster rate compared to other developed countries counterparts. In contrast to sound economic recovery and low unemployment rate (5.4%) in the U.S., the European Union members are still plagued by mounting debt crisis, high unemployment rate and decrease in consumers and investors’ confidence. Spain’s unemployment rate was at 26.6 percent, according to the World Bank data in 2013, meaning that 1 in 4 person is jobless. The World Bank data in 2013 also showed that unemployment rate among youth was around 57.3 percent or half of the young people is without a job. Greece is still struggling to cope with its high debt and austerity economic policy which the world fears that Greece may exit the EU in the near future. In Japan, despite its expansionary monetary policy and quantitative easing as part of what is known as Abenomics, experienced a surprise technical recession in the second and third quarter of 2014, largely attributed to the government’s sale tax increase from 5 percent to 8 percent to pay down Japan’s huge amount of debt. A healthy and growing economy is often associated with the rise in investor confidence.
Another major cause is the U.S. Federal Reserve has ended its Quantitative Easing policy and begins to tighten its monetary policy. Many analysts expect the Federal Reserve to raise the interest rate in 2015 given that the U.S. healthy economy is showing positive sign of normality and full employment. Contrastingly, the European Central Bank (ECB) and the Bank of Japan (BOJ) are implementing its expansionary monetary policy and Quantitative Easing program aimed at stimulating the demand in the economy and targeting inflation rate at around 2 percent by significantly increasing the money supply in the economy. The ECB has announced a 1.1 trillion euro quantitative easing plan by making a monthly purchase of 60 billion euro of government bonds and private sector assets. The Wall Street Journal reported that the BOJ also intensified its already aggressive quantitative easing plan by raising its annual asset purchase from 60 and 70 trillion yen to around 80 trillion yen (730 billion dollar). J.P. Morgan’s strategist Dr. Kelly stated that investors are pouring capital to the U.S. by buying the U.S. dollar expecting to reap the benefit when the Federal Reserve begins to raise the interest rate in the near future.
Third, the U.S. 10 year government bond is currently yielding around 2 percent, although is a small return, is relatively more impressive than the near 0.2 percent yield of Germany’s 10 year government bond and other developed market. The higher U.S. government bond yield has attracted a huge capital inflow into the U.S. and increased the demand of the dollar. The simple economic concept of the law of demand and supply will explain that the increased demand of the dollar will accordingly amplify the price of the dollar in the international currency exchange market.
Another likely contributing factor is the revolution of U.S. energy which cut U.S. import of oil significantly over the past few years which was made possible by the previously high oil price which enabled U.S. energy companies to make profit from extracting oil from the oil shale. In 2005 the U.S. imported 12.5 million barrels of petroleum a day or 60 percent of the total daily petroleum consumption. In 2013 the percentage of daily imported petroleum dramatically dropped to only 35 percent or 6.6 million barrels, according to Dr. Kelly’s article. Such reduction in oil import has reduced the U.S. trade deficit and saved billions of dollars. According to Flanders & Dryden, strategists at J.P. Morgan, all else being equal, a lower supply of dollar in the market leads to a dollar appreciation.
The sharp fall in commodity prices has also been a major negative impact on the economy of emerging markets. Countries which rely on commodity exports including Russia and Brazil have seen their currencies value drop sharply against the dollar.
This post is getting uncontrollably long and so for the sake of simplicity, we will end it here. There will be a continuation of this post and we will look at the effect of a surging dollar on the U.S. economy, the world economy and what it means for investors. Until then, have a great weekend.
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