The US Dollar has reached pre-financial crisis lows

Posted on : Mon, 25 July 2011

The US dollar is currently trading at levels which are close to historical lows, according to analysis by QNB Capital. The Federal Reserve’s US dollar exchange-rate index fell to 94.1 in April 2011, its lowest level since 1995. It remains close to this historical low and has been moving in a narrow range betweem 94.9 and 96.5 since April 2011. The last time the dollar index was trading in this range was in March-August 2008, just before the financial crisis.

The Federal Reserve’s dollar index is a trade-weighted index of exchange rates. Currently, the strongest weights are given to the Chinese renminbi (20%), the Euro (18%) and the Canadian dollar (13%). When there is weak demand for the US currency relative to these currencies, the index will depreciate.

Demand for US dollars is driven by a number of factors. A large amount of world trade is conducted in US dollars, including oil, and demand for dollar-priced goods will have an impact on the exchange rate. Strong GDP growth in a country will lead to rising imports and exports, the balance of which will have an impact on the country’s exchange rate. Interest rates and inflation are also important—if US interest rates are high and inflation low relative to other currencies, this will increase demand for the dollar as investors seek higher real yields for their capital.

However, in recent years, the most important factor driving the value of the US dollar has been related to its safe-haven status, according to QNB Capital. The US dollar, along with US assets, particularly Treasury bonds, has traditionally been regarded as a relative safe haven owing to the comparatively low inflation, large financial resources and economic might of the US. Perceptions of risk can be measured by stockmarket performance. If financial and economic risk is perceived to be low, investors will tend to sell safe dollar assets and invest in other regions, lowering demand for US dollars. As a consequence, this will drive demand for foreign investments and have a positive impact on global stockmarkets.

The importance of the relationship between global stockmarkets and the dollar index can be illustrated by measuring the correlation between them. Correlation is a statistical measure of the relative strength of linear relationships. The negative correlation between the US dollar Index and the Dow Jones Global Index (DJGI), a global stockmarket index, was -77% from 2002 to 2011, which can be described as relatively strong. Since the financial crisis, this correlation has risen to -97%, a very strong relationship. This means that an increase in global stockmarkets usually occurs alongside a decline in the dollar index and vice versa.

This is born out in practice. The DJGI rose 88% from 171 in January 2002 to a peak of 321 in October 2007. This would have involved a shift from safe dollar assets to riskier global equities and lower demand for US dollars. According to QNB Capital, this was an important factor in driving the dollar index down to the 95 level by mid-2008. Other factors included cuts in the Federal Reserve’s target interest rate from a mid of 5.25% in August 2007 to a mid of 0.125% in December 2008, which would have reduced demand for US dollars.

The financial crisis dramatically reversed this trend to sell US dollars and invest in global markets. From mid-2008 to March 2009, global stockmarkets fell 43%. The demand for US dollars increased sharply as investors sought safety, switching to low-risk, dollar-denominated assets. This was most probably the main impetus behind the 21% increase in the dollar index from 95 in July 2008 to 115 in March 2009. Between March 2009 and April 2011, the global economy recovered from the financial crisis and the recession that followed it. The DJGI rose 80% and this led to a recovery in risk appetite and a 15% decline in the dollar index.

Since April 2011, concerns about the global economic recovery have dampened market sentiment. Worse-than-expected economic figures from the US, worries about a possible default by the US government and a sovereign debt crisis in the Eurozone, have contributed to a retrenchment in global stockmarkets. The DJGI fell 5.3% between April and mid-July. Unusually, the dollar depreciated (0.5%) during this period, delinking from its previous correlation with global stockmarkets. This suggests that the safe-haven status of the dollar has been questioned due to concerns about the US economy, according to QNB Capital. However, it is likely that the US government will reach a consensus on raising the debt ceiling, which should reassure markets. This will probably lead to the dollar reasserting its safe-haven status and its traditional correlation to global stockmarkets.