Wednesday, October 21, 2009

Why The Weak U.S. Dollar?

The U.S. dollar lost even more ground today, and for the first time in more than a year, the euro rose above the $1.50 level.

While this apparent renewed strength for the euro is causing some European officials, particularly in France, to complain, the fact is that this move really doesn't reflect euro strength, but dollar weakness.

In fact, the U.S. dollar has weakened against almost all currencies this year, with the only exception being the Japanese yen as well as various currencies that are in effect pegged to the U.S. dollar (including the Chinese yuan).

While the dollar has dropped 7.5% against the euro this year. it has dropped 12% against the pound, 13% against the Swedish krona, 15% against the Canadian dollar, 23% against the New Zealand dollar and 25% against the Australian dollar.

That the dollar is so weak right now is all the more surprising given the money supply statistics I recently discussed, as most countries have a lot higher money supply growth than in America. So what is going on here, a lagged effect of previous money supply growth?

It probably to some extent reflects lagged effects of previous money supply increases, but not by much as money supply changes affect financial markets much faster than consumer goods markets. Instead, the most important factor involves demand for currencies, not supply.

The U.S. dollar has in fact become a "negative beta" asset in the minds of investors, just like the yen and to a lesser extent the Swiss franc. "Negative beta" means that it has a negative correlation with stock market movements. Whenever stock markets sell off, it "should" rise in value, whenever stock market rally it should decline in value. A theoretical explanation for this can be found here.

The stock market rally that we have experienced has therefore led to a big drop in demand for the U.S. dollar and the yen, while increasing demand particularly for the dollars of Australia and New Zealand.

Paradoxically, because of this demand factor, high money supply growth outside the U.S. could actually in the short term increase the exchange rate value of the countries with higher money supply growth. The reason for this is that as this could create a short-term boom in those countries, it could cause stock markets to rally, something which might increase demand more than supply. In the long term though, the money supply increase will lower the exchange rate as the increase in demand disappears with the initial boom.