How Bad Is the Dollar's Fall?

The US Dollar has been in decline against the currencies of its key trading partners since January 2002. It takes considerably more Dollars to buy the basket of key currencies than it did in January 2002, but only slightly fewer than it took in January 1995.

What is in the Dollar Index? The Atlanta Fed index is based on 1995–97 bilateral trade weights for 15 currencies. The European subindex includes the European Monetary Union, Switzerland and the United Kingdom. The Pacific subindex includes Australia, China, Hong Kong, Japan, Malaysia, Singapore, South Korea and Taiwan. The Americas subindex includes Brazil, Canada and Mexico. The overall dollar index includes the Saudi Arabian riyal along with the foregoing 14 currencies.

So, where does the Dollar index go from here? Opinions are strongly divided as recent extra volatility in the FX market has shown.

You can place your bet on the US Dollar index with futures contracts, or with one of two ETFs ((UUP) for a rising Dollar, or (UDN) for a falling Dollar).

Is the current situation terrible, because the dollar has fallen so much in the last 6 years - or was the situation in 2002 an artificially high period for the Dollar?

In this week’s Barrons, Carl Weinberg, Chief Economist of High Frequency Economics predicts that the Dollar will rise when the Fed stops cutting and begins raising interest rates.

Certainly, interest rate differentials between currencies and the direction of interest rate changes have strong impact on exchange rates. Mr. Weinberg may be correct that the Dollar will rise when rates rise again, but we think it would be dangerous to make a currency bet on that parameter alone.

Consider the chart below that shows the history of the Fed Funds rate over the period from 1995. It would be quite difficult to draw a cause and effect relationship between Fed Funds rates and the exchange value of the Dollar when you compare their charts.

There are other important issues; including trade balances, inflation rates, real interest rates (nominal rates less inflation), macro-economic reports, geo-political risks, relative central bank rates between countries, and the expectations of speculators who dominate the key exchange markets.

Crisis and panic as we have seen in the credit market as of late, have a significant impact on exchange rates. For example, the FX market lurched in both directions in the days surrounding the Bear Stearns (BSC) collapse and the coping moves made the the Fed.

Exchange rates are a matter of supply and demand of currency pairs. Many factors drive supply and demand.

US Dollar Index Trade Weighted Components:

Investors have single currency access to the six most important currencies in the US Dollar index through these ETFs or ETNs:

• (FXE) (Euro)
• (FXC) (Canada)
• (CNY) (China) - ETN
• (FXM) (Mexico)
• (FXY) (Japan)
• (FXB) (United Kingdom)

ETFs pay distributions and ETNs do not. ETNs incur imputed income tax liabilities according to a recent IRS ruling.

The US Dollar, the Euro and the Yen are most important currencies in the foreign exchange markets by trading volume. Foreign exchange volume is over $2.5 Trillion per day, and is greater in value than the sum of all other investment markets, including stocks, bonds, real estate, and commodities.

Major reserve surplus countries are beginning to diversify their liquidity into multiple currencies. Doing the same with individual liquidity reserves could make sense in some cases. Today there are several vehicles for investors to accomplish currency diversity, if they seek it.

Comments

[rdial54]

I think that the dollar will be back again at some point this year.

[pritchet1]

The US Dollar needs to get back on the Gold standard or we will loose it completely to the Amero.

[cheapybob]

From looking at the graph of the trade weighted dollar, you can see that there is something drastically wrong. What's misleading, IMO, is that we are buying oil in dollars, and if instead, we were buying it in the home currencies of the countries selling it, or ruples, as VZ has proposed, it would change the graph dramatically. As our foreign debt increases, so will the likelihood of this happening.

[ellensprophet]

When the bush presidency ends the dollar will stage a celebration rally.

[Whidbey]

When the Bush presidency ends it very much depends on who succeeds him. The dollar pairs respond to the security the dollar offers from political instability as compared to the other currency in the pair, and the capacity of the US to hold its dollar's relative stability. In the longer run, however the dollars value turns on its "store of value" characteristics. As the proposals to to bail out the housing market progress in Congress, the value of the dollar on just a demand/supply basis will fall in all likelihood; Congress will inflate away value. Domestice policy, Congessional spending rectitude in particular, is what demands our dollar future. It is not looking good, but very generally all currencies are inflated. Ellensprophet is wrong, but she is accustomed to that.

[mark mchugh]

What's most interesting to me is the dollar's problems began when the "recovery" began. So most foreign investors have been watching their US equity gains of the last 5 years evaporate in their home currency.

[GKM]

Wow that Chief Economist Carl Weinberg is a rocket scientist for sure. To think at some point when the Fed stops cutting rates and starts to raise them that the US dollar might go up? That is absolutely Nobel prize winning intelligence there. I think I learned that in Econ 101 but then again I don't have the title Chief Economist so what do I know.

I've been short the Euro for about two weeks now. The dollar recovery has already begun at least for the medium term. Deleveraging will continue to drive inflows into US dollars and the Fed will be up against it to cut much further in the short term. The market knows this but apparently Carl Weinberg is still skeptical/stuck in Econ 101.

[Edward Ulysses Cate]

If there was some point of stability, the dollar index would be of interest. With all currencies being fiat and central banks co-ordinated, it's seems like playing currency Whac-A-Mole on a pontoon boat with the tide going out. Not trying to be silly, but if central banks ALL inflate their currencies thus lowering their values, how can we measure any value.

[sedek]

"The US Dollar has been in decline against the currencies of its key trading partners since January 2002."

Low interest rates and increasing deficits will do that to a currency.

"It takes considerably more Dollars to buy the basket of key currencies than it did in January 2002, but only slightly fewer than it took in January 1995."

Perhaps because those key currencies have also been devaluing by printing money like paper is free? I believe the comparison currencies have also fell to gold, oil, and other commodities and metals, just not as fast as ours has.

As for the relationship between Fed rates and Dollar strength, Euro was at $1.26 when we had 5.25% to burst the housing bubble, then went to $1.59 in anticipation of a full 100 bp cut last Tuesday after the BSC bailout and the new offer of cheap money to nearly everyone with questionable paper as collateral. The Dollar then strengthened because FOMC "only" delivered 75 bp, with two dissensions, and mentioned the word "inflation" in the press release, which I saw as jawboning rather than course correction.

Dollar will remain weak as long as FOMC and the US government continue to do more of what has already weakened it, rate cuts and deficit stimulus, the recent Deficit Stimulus Act being but the first installment of congress bidding for votes with our grandchildrens' money.

[Maniac in Motion]

We're reaching a bottom for the dollar. Coming from the biggest dollar bear, that's saying a lot.

Central banks are now intervening to keep the dollar decline moving further. The dollar weakness is threatening how global companies do business. Foreign companies have already complained to government that revenues and profits are being hurt because the revenues earned from America convert to weaker profits in their home countries. Weaker profits make for weaker earnings per share, damping down stock price. On the flip side, the dollar weakness inflates earnings for US companies because of the currency exchange, which is why I'm getting slightly more bearish on US equities.

As a result, central banks are making coordinated efforts to buy more Treasurys, which keeps a further dip in the dollar in check. People's Bank of China, Bank of Japan, Bank of Israel, Bank of England, and the European Central Bank are all accumulating treasurys at these price levels. For instance, if the European Central Bank buys more US treasurys, then it keeps the Euro/USD ratio from rising further, which would hurt profits for companies in the EU. Plus, when the dollar goes up in value, they have an awesome accumulation of treasurys they bought on the cheap.

Thinking an entire country will go belly up is ridiculuous. It's foolish to think we'd go back to a gold standard. We are a global, fiat currency system. One developed country's currency weakness will not undermine every developed country's currency. What next? Are we going to start jumping on horses and stagecoaches because gas is too expensive in the short-term? Yes, there is some doom + gloom being circulated, but don't fall for the gold conspiracy like so many others. Gold is not an inflation play, and it's definitely not a currency play at these levels either.

If you wanna protect, just buy another currency. Although with meaningful central bank interventions around these levels, it may already be too late.

[Kunst]

Right on, Maniac, from another big-time dollar bear. I have been short the dollar (RYWBX) for the last 2 years. I am now completely out of that, and gold (on 3/17, nice luck on that). The dollar has been beaten up pretty badly, but it's time for a reversal, for now. Long-term, we'll see. Those trade and budget deficits are a bit of a problem.

Rather than go to a straight dollar-up fund, I am in ultrashort oil (DUG) and basic materials (SMN) ETFs. I do believe those will be a happy place for a while. Commodities have been doing a mini-bubble that is now correcting, much of it based on the weak dollar. Again, long-term, different story.

[Jason Hamlin]

Every time during the 6-year gold bull/dollar bear, whenever there is any correction in gold or hint of a dollar rally, people come out of the woodwork to say the commodities bull is over and the dollar has bottomed. Any they have been wrong time and time again.

Gold is certainly an inflation hedge and while some people will continue bashing the "barbaric relic," it has beat just about any other investment that you could have made over the past 6 years. My money says it will continue to do so and the dollar will continue to lose value. The fundamentals have not changed. The Fed can still lower rates to 0%, as it did during a very similar economic situation in the 70's. Stay long gold and short the markets.

[redrtbob]

Huge "off the books" funding for Iraq and Afghanistan can only continue the decline of the dollar. What is the real deficit? The Fed is going to be dumping dollars into the system and keep pushing rates down. . .doing "whatever it takes" even if it means a weaker dollar for a number of moths more

[sedek]

Maniac: "Plus, when the dollar goes up in value, they have an awesome accumulation of treasurys they bought on the cheap."

And this is why I don't see a major, long term strengthening of the Dollar, as it would effectively increase the cost of redemption of debt. Most likely is an ad hoc fixing of the Dollar around $1000/gold, so funny-money debt can be repaid with funny-money.

[Philly Jim]

Last time rates were near 1-2% lenders gave out money like it was nothing, if rates go back down near those levels it will be very interesting to follow where that cheap money goes; it definitely isn't going to consumers with poor credit like before. I feel like it's going to be giving a major "boost" for capital spending in the states which will translate to major infrastructure improvements in the states. I feel like the dollar will rally a lot after we start to see the benefits from this spending and the fed slowly brings the rates back up to 5-6%. I don't care how many high rises or western style businesses pop-up abroad, you just don't have the same wealth protections as you do here in the states.

[virilio]

"When the bush presidency ends the dollar will stage a celebration rally" vs "When the Bush presidency ends it very much depends on who succeeds him".

nothing is ever sure. They might as well throw dice as the dice are more predictable.

Could be under Clinton/Obama it is uncovered war was far more expensive than stated & USD keeps going down for several years. Could be under McCain it is not uncovered and people just assume this & USD keeps going down for several years. Could start going up too. Will global currency reserves go below 50% on the USD? Unlikely. If so I'd expect proportional devaluation of USD, and correct for it by estimating shifting distribution in my currency basket.

"so funny-money debt can be repaid with funny-money. " yep.

"if central banks ALL inflate their currencies thus lowering their values, how can we measure any value." IMHO relative to one another via shifting global currency reserve ratios

"Huge "off the books" funding for Iraq and Afghanistan" yep.

"If you wanna protect, just buy another currency." yep. or currency basket at ratio like central bank global reserves such as 60% USD, 30% EUR, 5%GBP, 5%CHF.

"The US Dollar needs to get back on the Gold standard" gee, why not just peg it to the price of a barrel of crude? *sigh*

[virilio]

"Last time rates were near 1-2% lenders gave out money like it was nothing, if rates go back down near those levels it will be very interesting to follow where that cheap money goes"

borrowed for next to nothing to short YEN EUR GBP CAN CHF on their red-days. Like the low-interest CHF was borrowed & converted to short USD against EUR, so low-interest USD could be borrowed & converted to short YEN against EUR.

[Mr. G]

I think the most recent rise in the dollar (five cents against the euro) was FED action. This is the first time they lowered the rate with out increasing the money supply. Typically,lowering the rate makes the dollar weaker against the euro based on interest rate preference,but the move was counterintuitive. I can see nothing in the near future that supports the dollar and I expect it to retrace lower considering the fundamentals coming down the pike.

[dfloydr]

I believe it was Carl Weinberg who, in 2000, predicted that oil would revert down to aan appropriate $25/bbl price within a short time. Hmm. ... define short?

[dfloydr]

I believe it was Carl Weinberg who, in 2000, predicted that oil would soon revert back down to an appropriate $25/bbl price. Hmmm... Defince soon?

[Michael B. Krause]

Take a look here.. This is coming to seekingalpha - a pro-USD argument.

scriabinop23.blogspot.com/2008/03/on-usd...

[FD-Condo-Hotel-South-Beach]

I think that you cannot ignore the political side of this. The current administration is one of the major cause for the weak dollar.
Off the book funding for Irak, huge deficit are for me major causes.
But I think that as soon as we get a new President, people will start having hope again. Every new president worldwide brings with him a wave of hope. It can be possible that this wave of hope will restart the economy and restart the US$.
Just my opinion.
FD @ condhotel.com

[johngonole]

If house prices stabalize than the dollar will stabalize. As long as house prices droop the Fed will print and put it into circulation via govt deficit spending to bail out the banks and prevent a depression. In essence they will confiscate the wealth in terms of dollar value of savers to pay for the excess of the irresponsible. The rich protect thier businesses this way and help the poor. The middle class gets their purchasing power wiped out and continue to work their asses off for these pigs.

The pigs are the wisest of all animals.

I personally don't care if the dollar is backed by gold, silver, govt owned land, steel, oil.........but it should be backed mostly by hard assets. Even if the basket of hard assets fluctuates it would prevent them from simply printing money. The booms and busts have always been caused by monopolist, central planners, and government interventionism of one form or another.

The backing of the dollar doesn't have to be perfect I mean because fractional reserve banking isn't perfect. But our currency is almost 100% backed by the faith that our government can pay back all that debt. And now the Federal reserve is backing our currency with bad mortgages. Our government is about to enter an era of forced high spending via medicare and social security. Sounds like our currency is more and more like a house of cards.

I think the fact that oil is traded in dollars is the main thing that has allowed the world market to soak them up without affecting us. Imagine if all those foreign owned dollars all the sudden came over here and were spent. Yes we would all have work but everything would costs so much. Hyper hyper inflation. Our land would be bought etc...

If the Federal Reserve would just bow out after the bail out this time and stop intefering perhaps we could actually work ourselves out of all this debt. Its almost as if they want everyone to be broke.

[phdinsuntanning]

we think it would be dangerous to make a currency bet on that parameter alone? just look 1980-1985 !!!

[clitosil]

Yes, once again, the dollar is backed by a hard asset: oil. Oil is the main inflation hedge to play.

[Silver-Bullet]

Yes, oil and may I add gold.

To put this in perspective, beyond paying for the war, trade deficit, pork barrel projects, global military build up.... do not under estimate what I consider the grandfather of all bear scenario:

The US ENTITLEMENT PROGRAMS (social security, medicare, medicaid, etc) was estimated to be at about 2/3 of the federal budget. This figure is in the trillions of dollars.

MSNBC: www.msnbc.msn.com/id/10609044 /
The Heritage Foundation: www.heritage.org/research/features/Issue...
Wiki: wiki.answers.com/Q/What_percentage_of_th...

This will play itself out in the next 20 to 30 years, when 60 million boomers begin to retire. They will be collecting more and using more, and contributing less. Yes, it's payback time for them.

Make not mistake, the US government is bankrupt and has already dipped into the social security cookie jar for sometime. If history repeats itself in fiat currencies, there is a 99% chance that the US government is going to print more and more money. Why else do they stop publishing M3 money supply a few years back.

A second factor that will aggravate the dollar decline is oil, or the lack there of. There are no new and bigger oil fields discovered, there is vehement opposition on oil exploration within the borders of US. Oil can rise to $200, $300, $400.... and the cost of gasoline to string beans will sky rocket.

The public probably thinks that gasoline comes from gas station - NOT. It originates from oil fields. Oil can be at $1,000 a barrel and it is still not a bubble because by definition a bubble is when price increase when there is an excess supply of the item of interest. Again, where are the new and larger oil fields?

The future is bleak for all who holds US$, especially those who are retiring as they are at the end of their productive years and have most of their wealth in the 'safety' of cash.