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Economics Exchange Rates Commentary Essay

NEW YORK (Dow Jones)–The dollar continued its slide Wednesday, touching its lowest level in 12 months against the euro and flagging against the yen as rising equities battered the greenback yet again.

The dollar has lost key legs of support over the past two weeks as encouraging global economic data has led investors to assume more risk and buy higher-yielding assets. With the recession receding and financial markets in recovery, investors have become more confident there’s no longer a need to hold their money in a safe-harbor currency like the dollar.

Because of the Federal Reserve’s need to stimulate the economy, the dollar’s ultra-low interest rates have made it the lowest-yielding major currency. The cost of borrowing U.S. dollars in the London interbank market continued its slide Wednesday. The key three-month London interbank offered rate marked its lowest level since the British Bankers’ Association first introduced its Libor fixings in 1986.

The dollar hit its lowest level against the common currency since September 2008 in New York afternoon trading, with the euro touching a 12-month high at $1.4738. If the euro is able to sustain levels above $1.4720, a key technical level, it could be on a march to $1.50, said Carl Forcheski, vice president for foreign exchange at Societe Generale in New York.

The dollar’s losses were broad, sinking to new 13-month lows against the Australian and New Zealand dollars as well as lows for 2009 versus other widely traded counterparts. The U.K. pound also piggy-backed off the euro’s gains to advance on the dollar.

The yen had been the so-called “carry trade” currency of choice, but with U.S. interest rates expected to remain feeble until 2010, analysts anticipate the dollar to continue funding riskier bets. A carry trade involves buying a lower-yielding currency to fund purchases of higher-yielding assets.

The dollar was also burdened Wednesday by comments from Japan’s incoming finance minister, Hirohisa Fujii, who said he saw no need to intervene in currency markets to weaken the yen. In the past, the dollar had received support from the belief that Japan would intervene to prevent unwanted appreciation of its currency. “There’s no change in my thinking” that it’s not the time to consider foreign-exchange intervention, Fujii said at a news conference.

Though he wouldn’t rule out intervention in what he termed “really abnormal situations,” Fujii said “the idea that the yen should be cheaper for the sake of [Japan’s] exporters is wrong.” Wednesday afternoon in New York, the euro was at $1.4729 from $1.4667 late Tuesday, according to EBS via CQG. The dollar was at Y90.78 from Y91.06. The euro was at Y133.72 from Y133.60. The U.K. pound was at $1.6506 from $1.6495, while the dollar was at CHF1.0306 from CHF1.0340.

U.S. economic data released Wednesday, including as-expected August consumer price index and better-than-expected industrial production numbers, pointed to a continuing recovery, leading stocks to rally. The Dow Jones Industrial Average rose 108 points, lending support to the euro and other high-yielders.

The dollar looks likely to continue its broad-based slide through the rest of the year, analysts said. As long as the buck doesn’t fall too far too fast, dollar weakness is expected in a time of loose monetary policy, said Adnan Akant, a currency specialist at money manager Fischer Francis Trees & Watts, a New York unit of BNP Paribas. Right now, the euro and other higher-yielding currencies are reaping the benefits of a global economic turnaround and stock market rallies, but within the next 12 months, the dollar should start benefitting from a recovering U.S. economy, said Wells Fargo analysts.

The Canadian dollar ended higher near its strongest levels of the day Wednesday, reflecting another sustained flight into riskier assets like stocks and commodities at the expense of the slumping U.S. dollar. The U.S. dollar was trading at C$1.0666 late afternoon, from C$1.0721 late Tuesday.

Strong gains for oil, gold and other commodities as well as rising North American equity markets underpinned the Canadian dollar’s gains, although the currency again failed to mount a serious challenge of its year-to-date high at C$1.0639, achieved in early August.

Commentary

The article refers to a depreciation of the dollar against major currencies due to “ultra-low interest rates” and increased risk by investors.

The Federal Reserve has been cutting interest rates in an attempt to boost aggregate demand and stimulate the economy. High interest rates in an economy generally encourage investment in that currency as the value of the investment will increase over time. Currently US interest rates set by the Federal Reserve are around 0.25% compared to the European Central Bank’s 1%. Because of this, investors have switched to higher yielding currencies, such as the Euro, and to a lesser extent the Pound, causing a fall in the Dollar’s exchange rate. This is shown in Diagram 1.

As the diagram shows, a right shift in the supply of the Dollar leads to a fall in its price relative to the Euro.

In addition, the aforementioned cutting of interest rates is an expansionary monetary policy used to manipulate aggregate demand. The trade off of this policy is increased inflation. A high rate of inflation might further decrease investment in Dollar assets as the real value of the investment would decrease over time. During times of economic crisis, investors tend to invest in low risk assets such as generally strong currencies like the dollar. However with signs that the global economy is exiting the recession and in recovery, not only does the demand for safe-harbor currencies like the dollar decrease, but there is an increased demand for high risk investment due to bullish speculation.

In addition, some consumers, firms, or foreign central banks might believe that despite the improving economic situation, the Dollar will continue to fall as the article mentions and sell dollar assets. This bearish speculation would further increase the supply of the dollar and perhaps lead to self-fulfilling prophecy.

As shown above, the combination of the three factors leads to a sharp fall in the exchange rate. As previously mentioned, this depreciation could cause a self-fulfilling prophecy in which the initial bearish speculation leads to depreciation, which in turn causes more bearish speculation causing the exchange rate to enter a downward spiral. Initially, the Federal Reserve might not intervene but if the depreciation continued, it would be forced to buy back Dollars to counteract the increases in supply. This would slow the depreciation, discouraging people from selling dollars. It might even create bearish speculation as some might assume the dollar market will bottom out and start to appreciate.

The depreciation of the Dollar should benefit the US economy by means of an improved current account deficit. Initially, the deficit will worsen as the demand for imports and exports is inelastic in the short run, but eventually the current account balance will improve as US exports become more competitive. US export revenue will increase while expenditure will fall. This improved current account situation will boost AD leading to economic growth. This is shown below in Diagram 3.

Diagram 3

However, as the diagram shows, in the long run, there will be the trade off of inflation as AD rises. This might encourage Federal Reserve to strengthen the Dollar to reduce imported cost-push inflation. In addition, the increased demand for US exports will increase the demand for the Dollar causing appreciation. Foreign nations might eventually implement import controls such as tariffs on US goods in order to preserve their own current account balances.

Eventually, the Dollar should regain its status as a high-yielding currency

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[ 1 ]. The value of one currency expressed in term of another [ 2 ]. A period in a business cycle following a recession, during which the GDP rises. [ 3]. Believing that a particular security, a sector, or the overall market is about to rise [ 4 ]. Revenue from the exports of goods and services and income flows is less than the expenditure on the import of goods and services and income flows in a given year


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