Strong Dollar, Weak Dollar, Both?

Today an article on Bloomberg informs us that the US Dollar is alive and well and further declines are unlikely even in the face of Bernanke’s efforts to print $600 billion more. Most of the article’s statements are based on the Dollar Index, which tracks the value of the dollar against currencies of the major trading partners.This index has appreciated during the last couple of weeks as the chart below shows.
Dollar Index

The thing about exchange rates is that they depend on relative rather than absolute merit. For example, if Country A maintains a booming economy while exercising fiscal restraint and reasonable interest rates, that doesn’t necessarily mean that its currency will appreciate relative to Country B. If Country B is doing the same things, just more and better, people will want to invest there and demand for B’s currency will exceed demand for A’s. Consequently, B’s currency will appreciate relative to A’s, of  conversely, A’s will weaken relative to B’s even though A looks mighty good in isolation. (Disclaimer: This is a gross simplification of what drives exchange rates, but hopefully it illustrates the point.)

Back to the Dollar Index. It measures the strength of the dollar against the Euro (57.6%), the Yen (13.6%), the British Pound (11.9%), the Canadian dollar (9.1%), the Swedish Krona (4.2%) and the Swiss Frank (3.6%). In other words, more than 75% of this index measures the strength of the US dollar against European currencies.

It seems likely that the strengthening of the dollar against European currencies has more to do with the European debt crisis than Bernanke’s policies. The US has just been the lesser evil for the last couple of weeks as investors took an ‘anything buy Europe’ stance in light of Ireland’s crisis and the expectation that the rest of the PIIGS (Portugal, Ireland, Italy, Greece, Spain) are not far behind. The appreciation of the dollar index really only looks like an endorsement of Bernanke’s efforts if one ignores what is happening on the other side of the equation.

The European crisis is a short-term market driver, Bernanke’s policies affect exchange rates over longer time frames. For the next weeks or months, the European crisis is likely to drive exchange rates and other markets, but over the next five to ten years, we will see the consequences of current fiscal policy.

Posted by Martin Gremm (Pivot Point Advisors)

About the author

Marc Schindler, CFP®

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