Dollar Strength and Why It's So Strong Right Now
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The U.S. dollar is strong when the dollar's value is high relative to other currencies compared to the past. This means one of two things. It can mean the dollar is near the top of its historical range. As measured by the DX.F, the all-time high for the dollar was 163.83 on March 5, 1985. That's because the U.S. Federal Reserve raised the fed funds rate to 9% to combat stagflation. The historical fed funds rate reveals the ups and downs since 1971.
The record low for the dollar was 71.58 on April 22, 2008. This was shortly after the Bear Stearns bank failure. At that time, investors fled to the euro because they thought the financial crisis was limited to the United States.
A strong dollar can also mean that the dollar rate increased over a short period. The dollar strengthened 25% between July 2014 and March 2015.
Why the Dollar Is So Strong Right Now
The dollar is so strong for three reasons. First, the Fed ended its expansive monetary policy as the economy improved. It stopped adding to the money supply. This constrained the supply of the dollar and increased its value.
The Fed also raised interest rates in December 2015. This strengthened the value of the dollar. It meant that U.S. Treasury notes would attract higher interest rates in the short-term. That increased the demand for dollars. Savers earned a higher rate of return on dollar deposits than on euro deposits, which paid lower interest rates.
Second, the European Central Bank lowered the value of the euro by doing the opposite. 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. That’s because the euro makes up 57.6% of the value of the U.S. dollar index. This means that whatever makes the euro weaker will make the dollar stronger and vice-versa. Each of the other currencies in the USDX has less influence on the dollar’s value.
Finally, forex traders intensified the strength of the dollar. They used leverage to further weaken the euro and strengthen the dollar.
This is the timeline of what happened from 2014 through 2016.
2014: In January, the Fed began tapering its quantitative easing program. The dollar remained in its 2013 trading range of around 80 for the first six months of 2013. Similarly, the euro traded at around $1.3767. In February, the pro-western forces in Ukraine overthrew its government, sowing 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. In March, the Fed announced as well that it would look at raising the fed funds rate sometime in mid-2015.
On September 4, the ECB announced it would begin its version of QE. In November, the ECB added it would maintain low interest rates.
2015: In January, the ECB announced it would begin QE in March. On March 12, it started buying bonds. 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. The dollar rose 25% from its July 11, 2014, low of 80.187. It closed the year at 98.01.
Throughout 2015, analysts predicted the euro would fall to parity or $1.00. As a result, hedge funds and other forex traders began shorting the euro. These included Bridgewater Associates, Tudor Investment, Brevan Howard, Moore Capital Management, Caxton Associates, and the Gavea Fund.
International investors know how to short the euro in order to profit from its potential devaluation. Traders who shorted the euro sold them on the spot market. This meant they promised to buy them in the future to replace the currency they borrowed from their forex brokers. They hoped the value of the euro would fall during that time. If so, they pocketed the difference as their profit.
Another factor driving the strength of the dollar in 2015 was a slowdown in China's economy. Potential credit problems scared investors into the safe haven of the dollar. As the world’s second-largest economy directly pegs its yuan to the dollar, China influences the U.S. dollar immensely.
In December, the Federal Open Market Committee raised the fed funds rate to 0.25.
2016: In January and February, the Dow fell to 15,660.18. It reacted 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 is the common measure for the strength of the dollar. This is a composite that measures the value of the dollar against the six the most widely-traded currencies. These currencies all use a flexible exchange rate. The amount of trade they have with the United States determines the exchange rate and weight of each currency. This 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. Treasurys. That increased the value of the dollar. It also lowered long-term interest rates. This combined with expansionary monetary and fiscal policy to strengthen the U.S. economy. That attracted more investors into Treasurys.