The Rise and Rise of the U.S. Dollar

Includes: UDN, UUP
by: Andy Singh

Despite global economic woes, one positive aspect for main street America has been the relatively rapid rise of the U.S. dollar in the last 3 months. The dollar index (DXY), a measure of the greenback against a trade-weighted basket of six major currencies, has strengthened by over 20% in this time.

However, the question is will this trend continue? To answer this, one must look at the current factors driving the U.S. dollar.

Why the dollar is rising

A number of analysts had predicted the continued demise of the U.S. dollar thanks to the financial-sector bailout and weakening economy but its sharp upside has surprised many. The dollar's recent climb is part of a massive reversal of long-standing investing trends (due to the global economic slowdown) such as buying emerging-market stocks or wagering on rising commodity prices. When investors retreat from such investments, they are often selling them in exchange for U.S. dollars.

The U.S. currency remains the most popular among global institutions, accounting for 55% of the assets and liabilities they hold in foreign currencies, according to the Bank for International Settlements. It has been further boosted because banks around the world are scrambling for dollars after inter-bank borrowing between banks all but ceased to function during the past month thanks to the liquidity crunch

After sending money overseas for years, U.S. investors are now bringing it home in a flight to safety. In July and August, the latest months for which Treasury Department data are available, U.S. investors sold $57 billion more in foreign stocks and bonds than they bought -- the largest-ever such repatriation. Dollar demand has also been reflected in the rise in purchases (and hence the price) of U.S. Treasury bonds, seen as the safest haven of all. The most recent data shows that such holdings of Treasury's increased by about $100 billion over the past four weeks.

Other countries are also feeling the effects (even more than the U.S.) and so are slashing interest rates to try and boost domestic economic activity, so the expected yield differential with the U.S. is falling. With this trend set to continue, investors will continue to flock to the dollar.

The U.S. economy is likely to recover faster than other economies because unlike other central banks, the Fed more than a year ago began lowering interest rates, which punished the dollar. Now it could be a positive, as other central banks catch up.

In the U.S., "a lot of the heavy lifting has already been put in the pipeline," says Stephen Jen, global head of currency strategy at Morgan Stanley, in the WSJ. "The same cannot be said of Europe."

The same old reasoning still applies: The U.S. is regarded as being able to weather a recession much better than the euro zone

As the dollar rises, U.S. consumers are seeing some clear benefits which overall should boost spending and assist with getting the nation out the current economic slump. Benefits of the high U.S. dollar to every day consumers include, lower oil and commodity prices, lower inflation (prices) and cheaper travel.

It does hurt foreign corporate profits and exporters, but given our economy is 70% consumer driven, I think what helps consumers is much more important right now.

Given the rapid rise in the dollar in synchronization with the escalation of the global financial meltdown and tightening credit markets, it stands to reason that as credit and stock markets stabilize so too will the dollar. This means it will give back some of its gains, but should be able to maintain current levels well into next year.

If the government implements much needed long term regulatory reform and adopts a more fiscally conservative policy once the economy has recovered, then there is a chance that the U.S. dollar could maintain its strength for a number of years to come.

Disclosure: none