You might have heard the phrase “strong dollar” and “weak dollar” thrown around by media outlets. What does that actually mean? We discussed in a previous blog post the implication of “strong dollar” and “weak dollar” on economies; if you haven’t read that blog, no worries – I will quickly sum it up in the next paragraph.
So, “strong dollar” versus “weak dollar”. “Strong dollar” means that you can buy more of a foreign currency with your dollar. In contrast, “weak dollar” means that you can buy less of a foreign currency with your dollar. For example, assume that the foreign exchange rate for the EUR/USD pair last month was: 1 EUR = 1.18 USD. This month, it has been in the news that US Economy has been booming and foreign investors want to invest in the United States. Due to this, the demand for USD increases. Consequently, the current foreign exchange rate is now: 1 EUR = 0.8 USD (hypothetical). You might have noticed that United States Dollar got “stronger” against the Euro. Earlier, you needed 1.18 USD to get 1 EUR, but now you only need 0.8 USD to get 1 EUR. This was an example of “strong dollar”. Conversely, if US Economy has a really bad quarter with high unemployment and low growth, investors are going to pull their money out of the United States and invest someplace else. Due to this, the supply for USD increases. Consequently, the foreign exchange rate will be: 1 EUR = 1.50 USD (hypothetical). As you might have noticed this time, the United States Dollar got “weaker” against the Euro. You now need more of USD to get the same amount of EUR. This was an example of “weak dollar”.
Alright, we all realize that foreign exchange rates fluctuate. US businesses that have international presence and have foreign companies in their supply chain are susceptible to currency fluctuations. Profits and losses can be heavily dependent on these foreign exchange rates. With all the US companies reporting their earnings in USD, the question we are addressing today is what moves USD? There are 4 things that can move the United States Dollar:
After globalization, companies and countries are dependent on one another. USD, which is pegged by at least 66 other countries, is a major currency in the foreign exchange market. With currencies trading in pairs, foreign currencies have an impact on the USD.
What do I mean by currencies trading in pairs? When you look at any foreign exchange quote it would have 2 currencies such as “EUR/USD”, “GBP/USD”, “USD/JPY”, “AUD/USD”, etc. When you convert your money, you are selling one currency and buying the other. So, if you are traveling to Europe and want Euros, you have to sell your USD to get EUR. When looking at the quotes, you can think of the numerator as the currency you are buying and the denominator as the currency you are selling. Let’s zoom into “GBP/USD” for a second. So, when people are overly optimistic about UK’s economy, they would be buying GBP (Great British Pound – Sterling). While doing so, they are selling USD in return, which increases the supply of USD. Due to the increase in supply, prices of USD drop. This is precisely what I mean when I say “with currencies trading in pairs, foreign currencies have an impact on the USD”.
Let me give you a couple examples of how fear moves USD.
Let’s say last month the foreign exchange rate for Canadian Dollar (CAD) was: 1 CAD = 0.8 USD. Canada is the 7th largest producer of oil. As oil prices rise, the price of Canadian Dollar (CAD) follows. In other words, as price of oil climbs, CAD gains strength. Assume that there is a shortage of oil now. This means that the demand for oil is going to skyrocket – pushing the price of oil up through the roof. As this happens, CAD gains tremendous strength. What does that mean? The foreign exchange rate is now: 1 CAD = 1.20 USD (hypothetical). As you can see, USD got “weaker” against CAD simply because the demand for oil increased (fear of shortage).
Another example. Australia is the 3rd largest gold producer. So, gold and Australian Dollar have a positive correlation i.e. when gold prices go up, Australian Dollar gets stronger. Let’s say last month the price of 1 AUD was 0.75 USD. Now, the world fears of a global meltdown – economies across the world are going to fail (hypothetical). People are flocking towards gold. Gold prices are on a rise, which means price of AUD is increasing simultaneously. As AUD gains strength, the foreign exchange rate is now quoted at 1 AUD = 1.1 USD (hypothetical). As you can see, USD got “weaker” against AUD simply because of fear of economies failing. During times of distress, people usually invest their money in gold or safe-haven currencies such as Japanese Yen (JPY) and Swiss Franc (CHF).
2. US Economy
If the US economy is booming – jobs get created, businesses report strong quarterly earnings/growth, unemployment stays low, people spend money freely – then this is a great sign for foreign investors. As the foreign money flows in the United States, the demand for dollar increases. Why does the demand for dollar increase? Simply because those foreign investors have to convert their local currency into USD in order to invest in the United States. This demand for USD pushes up the price of dollar – making dollar “strong”.
In contrast, if the US economy is in a recession – jobs are minimal, businesses are closing, people are losing their jobs, spending decreases – then investors are going to liquidate their investments in the US, and put their money somewhere else (maybe gold). As US investments are being liquidated, the supply of USD increases, which pushes the price of dollar lower. As a result, the dollar is now considered “weak”. Historically, when there is an economic turmoil in the US, investors flow towards gold. Consequently, USD and gold are inversely related – as dollar gets “stronger”, gold gets cheaper, and vice versa. In conclusion, the swings in USD are heavily dependent on the US Economy. Even one bad US unemployment data has the potential to fluctuate the prices of USD.
3. Interest Rates and Bond Yields
The US Federal Reserve increases interest rates when the US Economy is growing at a steady pace. Increasing interest rate is dollar bullish. Let’s quickly talk about carry trade, while we are talking about increasing interest rates. Millions of speculators and financial institutions are involved in carry trades on a regular basis. What is carry trade? This is when you borrow (sell) a country’s currency that is at a near zero interest rate (for example Japanese Yen), and you invest (buy) another country’s currency that is paying you a higher interest rate (for example Aussie Dollar). What’s in it for you? You get paid the difference in interest rate every day, every hour, until you hold onto carry trade. The higher the interest rate differential, the greater your every day payment. Unlike that 0.02% interest rate that your bank pays you every month, these interest rate differentials could go as high as 10% depending on the currency pair you pick.
So, as interest rates increase, bond yields would increase simultaneously. An increasing bond yield attracts all the foreign governments and investors. Chasing that higher return, which is safe and “default free”, foreign investors start pouring money into the United States. When investors buy US bonds, demand for USD increases, which pushes price of USD higher – making USD “stronger”. In contrast, during a recession, interest rates hit zero. So, all the bond investors looking for that safe investment with high yield would decide to get their money out of the US bonds and invest it in another country’s bonds (with low risk and higher return). This liquidation of US bonds increases the supply of USD, which pushes price of USD lower – making USD “weaker”. This is precisely how a fluctuation in interest rates and bond yields can move the USD and the foreign exchange market.
4. Other Economies
Good or bad news for one country can be adverse or favorable to another country. For example, when the European economy looks stronger than US Economy, investors are going to sell their USD investments and invest in Eurozone. This pushes the price of EUR higher and drops the price of USD (making USD weaker compared to EUR). Now you know why Euro is called “anti-dollar”. This bullet point (“Other Economies”) goes hand in hand with the first bullet point (“Fear”), but I wanted to make it evident that other economies can certainly move the USD as well.
Let’s wrap up. Now, when you hear “strong dollar” and “weak dollar” in the news, you know what is happening underneath the surface. If you are an international traveler, who is visiting a specific foreign country yearly, you can now hypothesize what’s making your USD “stronger” or “weaker”. It could be oil, gold, fear, another currency, or even some economic data. There is a lot more to the USD than just the legal tender.
Hope you learned a little and found this blog post helpful. We talked about the four major factors that can influence the United States Dollar. We discussed “strong dollar”, “weak dollar”, interest rates (carry trade), bond yields, and how fear and other economies influence the price of USD. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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