Why is the US Dollar Strengthening Versus Other Currencies?

Over the last year we have seen the US dollar appreciate significantly over other currencies. This is causing a variety of ripple effects both here and around the world. Let’s take a look at some of the largest moves over the last twelve months:

Dollar’s Appreciation vs World Currencies

Source: Google Finance as of 3/23/15

These numbers represent the gain in the dollar’s value versus each currency.  You can see Russia has seen the most dramatic move, while the Euro and the Yen have also had significant changes over the last year. Even when comparing the dollar to a broad basket of global currencies, the appreciation is significant.

Currency moves are always difficult to get your head around, as you have to think of everything in relative terms. When comparing the US and Russia, it’s a little easier to see why the dollar is appreciating versus the ruble.

• Economic growth: Our economy is predicted to grow about 3% this year versus a loss of 5% or more in Russia’s GDP. Advantage: US
• Oil prices: Although our oil production has dramatically increased over the past few years, we are a net oil importer. Lower oil prices help our economy. On the other hand, Russia is a net exporter, with oil representing about 70% of that country’s total exports. Lower prices have significantly affected their economy. Advantage: US
• International sanctions against Russia over the conflict in Ukraine have also hampered business there. Advantage: US

When comparing the two economies, an investor would likely conclude that the US is a safer place to invest with strong, diversified economy that is boosted by lower oil prices. This means the currency is also relatively safer and stronger compared to Russia’s, leading to a strengthening US dollar.

These kinds of calculations are going on daily with millions of data points, and with over 150 currencies worldwide.

The US dollar has appreciated compared to a broad basket of other currencies for some of the same reasons as it has versus the ruble; namely, a stronger economy than most countries.

Another factor coming into play with Japan and the European Union is the relative amount of each currency in the world. Just like widgets, if you increase the supply of your currency drastically, the price of your currency falls relative to others. The opposite happens when you reduce the amount of your currency in the marketplace by pursuing a “tight” monetary policy.

Here is one of our favorite charts illustrating the relative actions of the central banks in the US, Europe and Japan:

Source: JP Morgan

We can see from the grey line at the bottom that the Federal Reserve has drastically increased its asset base during the Great Recession and in the aftermath. A central bank’s asset base is one way to show us whether a country’s monetary policy is expanding or contracting.

While the Fed has grown its asset base over the last few years, the European Central Bank has increased its assets even more. And Japan has significantly outpaced both the Fed and ECB, especially over the last two years. So while we’ve increased the supply of US dollars in the world, even more Euros and Yen have been flooding the market.

The other thing to note is the projected asset base represented by the dotted lines. The Fed is projected to start reducing its supply of US dollars, mainly by actions such as the “taper,” meaning that it will not buy as many bonds, instead choosing to reinvest what it already holds.

While the ECB has cut down its asset base recently, it’s projected to resume the increase. And Japan looks like it will keep its aggressive policies in place for the foreseeable future. So while the supply of the Euro and Yen will keep increasing, the supply of US dollars will decrease. This steepens the trajectory of the US dollar versus these other currencies.

Generally speaking, a strong dollar is good for a country’s economy, but we are a little concerned about the rapid rate of change we’ve seen. The commodity market is usually a good place to see direct evidence of currency changes and there has been significant volatility in metals, coal and steel, and gas and oil. If some market players are not nimble enough to adjust to the swings we’ve seen recently, there could be some isolated trouble for those who are heavily leveraged and/or caught on the wrong side of a trade.