Brighter prospects for the US economy boost the dollar

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One would think that with more than $12.8 trillion in monetary and fiscal stimulus added to the American economic system, the dollar would be under considerable pressure.

Well, it's not that simple. The dollar did weaken to $1.4330 versus the euro at the start of the month, but has since strengthened to $1.3935 and is basically unchanged for the year. The reason? Institutional investors are not willing to part with the buck -- at least not to the extent some analysts believe they should.

Most recently, rising interest rates in the United States have lured investors to the greenback. "The simple way to look at it is from a perspective of interest rate differentials moving in favor of the dollar," Benedikt Germanier, a currency strategist with UBS AG (UBS) in Connecticut, told Bloomberg News. For example, the yield advantage of German two-year bonds versus a comparable U.S. note fell to 0.26 percentage point, its narrowest since March.
All in the same soup

Second, the logic of a rising euro and British pound versus the dollar, even with the U.S.'s large budget deficits and monetary policy intervention, strikes some as theoretically flawed, given fundamentals in Europe and the United Kingdom. Although Europe has a smaller budget deficit as a percent of GDP, the U.K. has a larger one, and even more important, "each economy is likely to emerge from the recession after the United States does," Economist Peter Dawson told DailyFinance Friday.

"Although credit markets have eased since the financial crisis' acute stage last fall, we're still in triage-like mode in terms of bank-to-bank relations and cash positions," Dawson said. "But history demonstrates that once growth resumes the search for return on equity will be on again, and according to my research the U.S. is still winning that race."

Dawson added that he expects the U.S. economy to enter a recovery in Q3; conversely, "the euro-zone recovery may not start until Q4 or even Q1 2010." That scenario "benefits dollar-denominated investments, which supports the dollar."

Further, the dollar is also being supported by a lack of follow-through by the inflation hawks and others who argue investors must seek safe havens in gold and oil to protect purchasing power, under the assumption that the dollar must weaken and U.S. inflation must rise.

"Inflation expectations are not there just yet,' VTB Capital said in a note to clients, Reuters reported Friday. "Gold's attractiveness as a safe haven asset is virtually zero at the moment, which is evident from the unchanged speculative positions in gold futures or ETFs [exchange-traded funds]." Gold traded Friday at about $937.00 per ounce, which represents a decline of 6.7 percent from the the yearly high of $1,005 reached in February.

"Overall, there's just a better tone regarding the prospects for the U.S. economy, and for international trade," Dawson said. "There's a mountain of cash out there waiting to be deployed on the first signs of growth, and it looks like those first signs will appear in the U.S. That will continue to support the dollar in the year ahead."

Economic Analysis: As is so often the case in the currency market, currency rates are less a function of budget deficits and more a contest of which economic zone can offer the better return on equity. Or, as institutional investors say, 'If I can make 40 percent on equity, I'll pay the 10 percent currency toll.' To be sure, the U.S. budget deficit is large and must be reduced, and it will keep the dollar weaker that it would be with a balanced budget, but, as has been the case for much of the modern era, it appears the major factor in the dollar's strength will be U.S. commerce. In other words, as the U.S. economy goes, so goes the dollar.
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