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Many Variables Predict Dollar Exchange Rate Movements

By Frances Coppola

Small and midsize enterprises (SMEs) that trade internationally and, therefore, would like to predict the dollar exchange rate’s up or down direction may well feel that the only way to do so in mid-2019 is with a crystal ball. So many factors influence the dollar’s value that lately, if you consider only one or a few, it may feel as though the exchange rate’s response is opposite to the way it’s supposed to behave.

To help SMEs sort through the confusion, this article discusses the many factors affecting the dollar’s exchange rate, their current behavior, and how they combine to determine the dollar exchange rate’s direction of travel.

 

Monetary Policy’s Primary Role in Predicting USD Strength

 

Since ending quantitative easing (QE) in 2014, the Federal Reserve has gradually raised interest rates to their present level of 2.75 percent, about half what they were in 2006 just before the start of the Great Recession. The Fed has also reduced the size of its balance sheet significantly. Between them, these monetary policy actions have reduced the quantity of dollars in circulation, not only within the U.S. but globally.

 

But global demand for the dollar has been rising because, increasingly, global trade is conducted in dollars. The combination of strong dollar demand with falling supply due to Fed monetary policy has caused the dollar’s exchange rate to rise considerably since 2014.1

 

The Fed has now stopped raising interest rates because of concerns about the outlook for growth and inflation in the U.S., though it is still reducing the size of its balance sheet. If all else was equal, the dollar’s exchange rate should have fallen since the Fed’s January 2019 decision. However, it seems to have had little effect on the dollar’s exchange rate. The Financial Times says that this is because other central banks have also backed off from interest rate rises, and some are cutting interest rates.2

 

For example, at its monetary policy meeting of June 6, 2019, the European Central Bank (ECB) reiterated its position that interest rates will remain very low or even negative for the foreseeable future. in a press conference, the President of the ECB, Mario Draghi, indicated that re-starting QE was under discussion.3 Low interest rates and QE both tend to weaken the exchange rate of the currency concerned. Thus, the euro could remain weak versus the dollar for some time to come.

 

But monetary policy is not the only influence on exchange rates.

 

Key Economic Indicators Help Predict Dollar Exchange Rate Strength

 

Markets respond to U.S. economic forecasts as well as to Fed monetary policy signals. Economic indicators that can help predict the dollar’s exchange rate include GDP growth, inflation, the unemployment rate, payroll data, production figures, and the size of the U.S. government deficit.

 

  • GDP growth: The U.S. economy grew strongly in 2018. Many analysts attributed this to the effect of the U.S. government’s tax cuts. However, GDP growth is now showing signs of slowing down.4
  • Inflation: Core inflation, which excludes food and energy, is running below the Fed’s 2 percent target. The Fed says that future inflation expectations are also below target.5
  • Unemployment and payrolls: Data from the Bureau of Labor Statistics (BLS) announced on June 7, 2019 showed the unemployment rate unchanged at 3.6 percent and employment rising very slowly.6 Wages are rising slowly, too, despite the low unemployment that usually drives them higher.7
  • Production: Industrial production fell 0.5 percent in April. Total output declined by 1.9 percent in the first quarter of 2019. Capacity utilization is below its long-run average.8

Collectively, these indicators suggest that the outlook for the U.S. economy is worsening. The dollar’s exchange rate tends to fall in response to gloomy economic indicators because markets anticipate that the Fed might respond by cutting interest rates.

 

Government deficit, though, acts differently on the dollar. Large government deficits can discourage investors from holding dollars or buying dollar-denominated assets. Thus, a rising government deficit may weaken the exchange rate or increase its volatility.

 

The U.S. government deficit has widened sharply in the last couple of years due to tax cuts. Changes in the tax code introduced at the same time as the tax cuts were expected to encourage corporations to repatriate profits to the U.S., which would then be taxed, thus increasing tax revenues. However, tax revenues have not risen enough to close the deficit.9 This may be contributing to turbulence in the dollar exchange rate.

 

Trade Tariffs can Affect the Dollar’s Exchange Rate

 

One key factor that may have helped strengthen the dollar’s exchange rate is trade policy. In 2018, the U.S. imposed tariffs on steel and aluminum imports from most countries, and on most goods imported from China. In May 2019 it lifted tariffs on steel and aluminum imports from Canada and Mexico after agreeing to a new trade deal with those countries.10 However, simultaneously it announced an increase in tariffs on Chinese goods.11 It is also considering imposing tariffs on goods imports from other countries, notably automobiles from Europe.12

 

When an exchange rate is floating, as is the case for the U.S. dollar, higher tariffs on imports tend to cause the exchange rate to rise. The dollar’s trade-weighted index started to rise when the steel and import tariffs took effect, and continued to rise throughout 2018.13 It steadied in early 2019 when China and the U.S. appeared close to a trade agreement,14 but rose again in May when tariff rises were announced.15 Of course, many factors help predict the dollar index, but the correlation between higher tariffs and upwards movements in the dollar index could mean that tariff increases are driving the dollar’s rising trade-weighted exchange rate.

 

The Euro’s Role in USD’s Trade-Weighted Exchange Rate

 

The U.S. dollar index (also known as the trade-weighted exchange rate) is calculated by reference to the currencies of the U.S.’s trading partners. The contribution of each currency to the rate is determined by the proportion of total U.S. imports that come from that country or bloc. Although trade with other countries—notably Canada, China and Mexico—has grown significantly this century, the Eurozone is still the U.S.‘s biggest trade partner. In February 2019, the euro accounted for 18.685 percent of the Fed’s broad dollar index, which includes 25 currencies.16 In the ICE dollar index, which only includes six currencies, the euro’s weighting is 57 percent.17 Because of the euro’s high weighting, particularly in the market-determined ICE index, the trade-weighted dollar exchange rate tends to rise when the euro’s exchange rate falls versus the dollar.

 

The euro’s exchange rate has fallen versus the dollar since early 2018 due to weak inflation and growth forecasts for the Eurozone.18 Wide divergence of interest rates between the U.S. and the Eurozone also encourages carry trades and issuance of “reverse yankee” bonds (euro-denominated bonds issued by U.S. companies outside the U.S.), both of which tend to weaken the euro relative to the dollar. All of this tends to drive up the U.S trade-weighted dollar exchange rate.

 

USD’s Safe Haven Role Also Affects its Exchange Rate

 

Investors regard the U.S. dollar and dollar-denominated assets, especially U.S. government debt, as “safe assets.” This means that the holder’s risk of loss is very low. The interest rate on the three-month U.S. Treasury bill is used worldwide as the closest equivalent to a risk-free rate. Thus, when global risks are rising and the outlook is gloomy, investors may sell riskier assets such as developing country government bonds in favor of high-quality U.S. dollar-denominated assets.

 

The dollar’s exchange rate can therefore rise when the economic outlook in other countries worsens or global political risks rise. So, The Wall Street Journal suggests that one reason for the dollar’s strength may be a worsening global economic outlook and slower growth in Europe and Japan.19

 

The

Takeaway:

The dollar’s exchange rate is influenced by a multitude of domestic factors and global forces. The Fed’s monetary policy decisions are key, but U.S. economic indicators feed into the Fed’s decisions, enabling markets to anticipate Fed policy changes. U.S. government policy decisions also influence the dollar’s exchange rate and may contribute to its volatility. External factors such as the monetary policy of important trade partners, changes in trade relations, and the global economic outlook also affect the dollar’s exchange rate. Finally, the dollar’s role as international safe haven means it can strengthen when the global economic outlook is worsening. Although some of these factors may weaken the dollar exchange rate, overall the interaction of all these factors has been keeping it strong and may well continue to do so.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. “Real Trade-Weighted Dollar Index, Broad (Goods),” FRED Economic Data; https://fred.stlouisfed.org/series/TWEXBPA
2. “Why the Fed changed direction but the dollar did not,” Financial Times; https://www.ft.com/content/362f1c62-6afd-11e9-80c7-60ee53e6681d
3. “Introductory statement to the press conference (with Q&A),” European Central Bank https://www.ecb.europa.eu/press/pressconf/2019/html/ecb.is190606~32b6221806.en.html
4. “Beige Book,” Federal Reserve; https://www.federalreserve.gov/monetarypolicy/beigebook201906.htm
5. “FOMC statement, May 1st, 2019,” Federal Reserve; https://www.federalreserve.gov/monetarypolicy/files/monetary20190501a1.pdf
6. “Employment Situation Summary,” Bureau of Labor Statistics; https://www.bls.gov/news.release/empsit.nr0.htm
7. “Beige Book,” Federal Reserve; https://www.federalreserve.gov/monetarypolicy/beigebook201906.htm
8. “Industrial Production and Capacity Utilization,” Federal Reserve; https://www.federalreserve.gov/releases/g17/current/
9. “U.S Deficit Widens to $319 Billion Amid Flat Revenues,” Bloomberg; https://www.bloomberg.com/news/articles/2019-02-13/u-s-budget-deficit-widens-to-319-billion-amid-flat-revenue
10. “Trump Removes Steel, Aluminum Tariffs On Canada And Mexico,” Bloomberg; https://www.bloomberg.com/news/articles/2019-05-17/u-s-poised-to-remove-steel-aluminum-tariffs-on-canada-mexico
11. “Trump just ramped up tariffs on $200bn worth of Chinese goods. Here are all the products that will get hit,” Business Insider; https://www.businessinsider.com/trump-china-trade-war-list-of-goods-tariffs-2018-9?r=US&IR=T
12. “Auto tariffs threat on Europe could be Trump ‘Trojan horse’: expert,” CNBC; https://www.cnbc.com/2019/05/15/auto-tariffs-threat-on-europe-could-be-trump-trojan-horse-expert.html
13. “Real Trade-Weighted Dollar Index, Broad (Goods)”, FRED Economic Data;
14. “U.S. and China Edge Close to ‘Epic’ Trade Deal, Says Trump,” BBC; https://www.bbc.co.uk/news/business-47729803
15. “Real Trade-Weighted Dollar Index, Broad (Goods)”, FRED Economic Data;
16. “Broad index of the foreign exchange value of the dollar: trade weights as of February 5, 2019,” Federal Reserve; https://www.federalreserve.gov/releases/h10/weights/default.htm
17. “US Dollar Index Contracts,” ICE; https://www.theice.com/publicdocs/futures_us/ICE_Dollar_Index_FAQ.pdf
18. EURUSD, Bloomberg https://www.bloomberg.com/quote/EURUSD:CUR
19. “Behind the bond rally, a strong dollar,” The Wall Street Journal; https://www.wsj.com/articles/behind-the-bond-rally-a-strong-dollar-11559467801

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