All Eyes on the Dollar

by: Finance Banter

The US Dollar hit another new low versus foreign currency on Tuesday morning. Continued concern over how robust the US recovery will be, loose monetary policy, weak employment reports, and reluctant demand for US paper have all added to the dollar’s decline.

Then yesterday, the Central Bank of Australia raised interest rates in a surprising move to begin tightening domestic monetary policy. This will drive an inflow of foreign capital to Australia and further depreciate the US dollar. Below is a chart of the exchange rate between the AUD and USD over the last year. The 40% rise since March speaks for itself.

Source: Yahoo! Finance

Source: Yahoo! Finance

A weakening dollar is bearish for the domestic bond market – the US government and corporations will have to offer higher yields on new bond issues in order to attract foreign investors. As yields go higher, bond prices will retreat.

The debate over the future direction of the dollar, however, is complex. We must remember that currency rates are a relative value proposition versus other global currencies. If the rate of economic growth picks up abroad faster than domestically, the dollar will continue to suffer. With Australia’s surprise move yesterday morning, there is speculation that some Asian and European central banks will follow suit. Do not expect that the US Federal Reserve will jump on that bandwagon and begin raising rates anytime soon. Bernanke has given no indication that we will see a move upward before mid-2010 and I would be very surprised to see that change against the backdrop of weak US employment reports. Unfortunately, the cost of capital for the US just went up.

Disclosure: None