Forex Markets: A Look Into The US Dollar, Part II

Welcome to part two of a four part series covering the current conditions of the foreign exchange market. This series of articles is focused on the dollar’s moves in relation to other currencies. The first part of this series is focused on the relationships between the Dollar and the Euro, commodities, and inflation and their role in the forex market. This part of the series will explain some of the reasons regarding why the Dollar has rallied recently in light of the financial crisis.

The moves in the currency market over the past couple of months have been extremely volatile and violent. Many currencies such as the Euro, Pound, and the Australian Dollar have depreciated against the Dollar at historic rates. Since reaching its high of $1.60 EUR/USD in May, the Euro has plunged over 21% to 1.25. The Euro has rapidly declined since August of this year due to many concerns including a flight to safety in U.S. Treasuries, a possible worldwide recession, the European Banking system and the U.S.’s TARP plan.

Flight to Safety

As many of the equity markets around the world have gotten slammed this year, many investors are seeking the safety of U.S. Treasuries to protect their money. U.S. Treasuries are believed to have zero default risk because the default of the U.S. government, the most powerful nation in the world, is almost impossible. Because of the low default risk on this fixed income security, it is one of the most liquid securities in the world. Considering the S&P 500 (^GSPC) is having one of its worst years in history, down over 45%, many general investors are re-evaluating their risk tolerance in equities and moving into less risky fixed income assets like treasuries. Markets abroad, such as London’s FTSE 100 index (^FTSE) and Tokyo’s Nikkei 300 index are down as much as 40% and 45% respectively, which has only added to the rush to U.S. Treasuries.

With the increased demand of this extremely safe asset, those who do not have Dollars must purchase Dollars in order to buy treasuries. This demand for Dollars has helped strengthen the Dollar against other currencies. The treasury has also been willing to supply these treasuries, as the demand has not only outstripped the supply, but they need to raise money to bail the U.S. financial institutions out to prevent another large failure.

Possible Worldwide Recession

Many economists believe that the U.S. government has helped steer the U.S. away from a deep depression, like the one that was experienced in the 1930’s, but a long recession isn’t out of the picture. Personally, I believe that this crisis will continue well into 2009, and we will be picking up the pieces from the U.S. financial services sector for a very long time. The Yen and Euro have fallen considerably following their announcements that they are in fact in a recession.

Although the U.S. hasn’t officially admitted that it is in a recession, many independent polls have found that over 75% of Americans do believe we are in a recession. If you add this to the consumer confidence index number of 38.0, the lowest ever recorded, I believe it is safe to say we are in one, and have been in one since at least January. Global economies, especially emerging markets, are extremely dependent on the strength of the U.S. economy and their consumers. The U.S. economy is in a slump, a slump that has and will continue to spread to the rest of the world.

U.S. and European Banking Industry

The banking industries, not only in the U.S. but also abroad, have had their credibility attacked regarding whether or not they have adequate capital to survive this credit crisis. Large financial institutions have failed, such as Wachovia (WB), Washington Mutual (WAMUQ.PK), Lehman Brothers (LEHMQ.PK), Bear Stearns, National City (NCC), etc. as a result of this crisis. Even the “Big 4″ U.S. banking institutions have lost a considerable amount of equity in the past 12-18 months. These events have pushed investors away from not only investing their money in these financial giants, but many have also pulled their deposits and other monies out in fear. Major reform has taken place such as these governments choosing to either force or allow the banks to choose whether or not they receive direct equity investments from their respective governments. Although this has helped, the underlying problem of falling home values have not been solved. Many top banks still have tens of billions of dollars of risky assets sitting on their books just waiting to be written down.

Since the summer, home prices have only lost more value, home foreclosures have increased, housing supplies have increased, and more people are now unemployed. This combination poses a perfect storm for these financial institutions to weather. If you add this onto the concerns of what regulation will arise from the newly president elect Barack Obama, and how quickly action will be taken only adds to the fear and uncertainty of investors.

Wrap-Up

Although the U.S. dollar has appreciated to other currencies mainly due to a flight to quality and the uncertainty of the equity markets, it may be short lived. The treasury is pumping out billions and billions of dollars at these low rates to fund their debt and to save the U.S. and world financial system. This massive issuance of debt is likely going to be the downfall of the Dollar’s strength as inflation will take over in the next coming years.

Disclosures: None

Subscribe by RSS Subscribe by Email