Dollar Strength and Why It's So Strong Right Now
The U.S. dollar is strong when the dollar's value is high relative to other currencies when compared to the historical dollar values. This means one of two things—first, it can mean the dollar is near the top of its historical range, such as the all-time high for the dollar on February 25, 1985, when the dollar hit 164.72, as measured by the U.S. Dollar Index - ICE (DX.F)—one of the few indexes that include historical information about dollar futures.
The all-time high was a result of the Federal Reserve (The Fed) raising the federal funds rate (the interest rate used for banks loaning to each other overnight) to combat stagflation (a high rate of inflation combined with economic shrinkage and high unemployment).
Second, it means that the dollar rate may have increased over a short period. For example, the dollar strengthened by 21% between July 2014 and December 2016. The record low for the dollar was in April 2008. This was shortly after the Bear Stearns bank failure which, among other factors, led investors to flee to the euro because they thought the financial crisis was limited to the United States.
Why the Dollar Is So Strong Right Now
The dollar is strong for three reasons. First, the Fed took two actions—it ended its expansive monetary policy (adding to the money supply) as the economy continued to improve following the Great Recession. This constrained the supply of the dollar, which had the effect of increasing its value.
Second, the Fed also raised interest rates in December 2015, which strengthened the value of the dollar further. A rise in interest rates has the effect of lowering bond yields, which reduces investor interest in U.S. Treasury notes in the short-term. This increased the demand for dollars and let savers earn a higher rate of return on dollar deposits than on euro deposits, which paid lower interest rates.
The European Central Bank took action by lowering the value of the euro by lowering interest rates, while political instability in the European Union also weakened the euro.
The euro to dollar conversion and its history shows how the euro has fared against the U.S. dollar through the years.
The dollar automatically strengthens when the euro weakens—this is because the euro makes up 57.6% of the value of the U.S. dollar index. This gives the euro a large influence on the value of the dollar—whatever makes the euro weaker will make the dollar stronger, and vice-versa. Each of the other currencies that make up the USDX has less influence on the dollar’s value.
Finally, foreign exchange traders (traders that trade derivatives of foreign currencies) intensified the strength of the dollar by using leverage (using debt to trade) to further weaken the euro and strengthen the dollar.
Dollar Strength Timeline of 2014–2016
In January 2014, the Fed began tapering its quantitative easing (QE) program. The dollar remained in its 2013 trading range of around 80 (indicated by the dollar index, USDX) for the first six months of 2013. Similarly, the euro traded at a six-month average of $1.3129.
In February, the pro-western forces in Ukraine overthrew the government, sowing the seeds of the Ukraine crisis. In March, Russia annexed the Crimean peninsula in Ukraine. In April, it sent forces to support pro-Russian separatists in eastern Ukraine. Also in March, the Fed announced that it would look at raising the fed funds rate sometime in mid-2015.
Announcements of rate changes by the Fed have an effect on the market, where investors react based on how they think the market will move after the change. This is called the announcement effect.
On October 2, the European Central Bank (ECB) announced it would begin its version of QE. In November, the ECB added it would maintain low interest rates.
In December, the euro's exchange rate fell to $1.21, as investors feared the Greek debt crisis would force Greece out of the eurozone. This diminishing value led the dollar to strengthen to 89.95 by the end of the year.
In January 2015, the ECB announced it would continue QE in March. On March 9, it started buying bonds, which increased the supply of euros in circulation and decreased the value of the currency. The euro fell to a 12-year low of $1.0524 on March 13. As the euro fell, the dollar rose. The USDX hit a 52-week high of 100.390 on March 13, 2015, rising 25% from its July 11, 2014, low of 80.030. It closed out the year at 98.27.
Throughout 2015, analysts predicted the euro would fall to parity (where the euro and dollar are equal in value). As a result, hedge funds and other forex traders began shorting the euro. These traders and fund managers included Bridgewater Associates, Tudor Investment, Brevan Howard, Moore Capital Management, Caxton Associates, and the Gavea Fund.
Shorting is an investing/trading tactic where an asset is borrowed by an investor, sold, and then purchased at a lower price by that investor.
Another factor driving the strength of the dollar in 2015 was a slowdown in China's economy. Potential credit problems scared investors toward the relative safety of the dollar. China directly pegs its yuan to the dollar—as the world’s second-largest economy, the Chinese market, economy, and currency influence the U.S. dollar immensely.
In December, the Federal Open Market Committee raised the fed funds rate to 0.24%.
In February, the Dow fell to 15,660.18 in a reaction to higher Fed interest rates. Investors didn’t like falling oil prices, the devaluation of the yuan, and the turmoil in China's stock market.
Dollar Strength Index
The U.S. dollar index (USDX) is the common measure for the strength of the dollar. This is a composite that measures the value of the dollar against the six most widely traded currencies. These currencies all use a flexible exchange rate, which means they are not pegged to the dollar, but instead use exchange rates as their valuation.
The amount of trade they have with the United States determines the exchange rate and weight of each currency. This table captures the risk that U.S. companies have to those currencies.
U.S. Dollar Forecast
Long-term, the large U.S. debt-to-gross domestic product ratio will reduce the dollar rate. Before the financial crisis, that's exactly what happened—as the U.S. debt grew, the dollar's value fell.
During the crisis, investors put their money into ultra-safe U.S. Treasuries. This increased the value of the dollar while lowering long-term interest rates. Combined with expansionary monetary and fiscal policy, this helped to strengthen the U.S. economy, which makes Treasuries more attractive to foreign investors, which in turn boosts the value of the dollar even further.