It’s been said, “You can’t keep a good man down.” In the financial markets, that man is the US dollar.
In response to the financial crisis of 2008, the monetary policy of the Federal Reserve has been one of the attempts to increase inflation, but this objective has not reduced the purchasing power of the US currency against others. Despite a long period of supplying the financial markets with many new dollars the value of our currency is strong.
Since 2012 when the Fed first considered a third round of bond-buying, or “quantitative easing”, the dollar has gained 8 percent and 33 percent against the Euro and Yen, respectively. Against all major currencies the dollar is 18 percent higher over these past three years.
One would think that such a change hurts the international trade position of the United States. Such is not the case. US exports of goods and services are 9 percent higher than they were in 2012. The balance on the US Current Account, the broadest measure of our trade balance, is 16 percent smaller.
The value of the dollar is likely to remain high because of issues well beyond the control of US policy makers. The Fed should stay focused on the home economy and seek better incentives for business investment here. We certainly don’t want a currency war.
The strong dollar has led some to claim that other countries are manipulating the value of their currencies to gain an export advantage against the United States. New federal legislation in Congress will allow the government to impose punitive duties on imports from countries showing a pattern of currency manipulation. Similar bills were introduced in Congress in 2011 but never became law.
The strength of the dollar, however, is not due to currency manipulation. The economic outlook outside the United States is simply weaker.
Central banks across the globe have followed the Fed’s lead and started their own forms of quantitative easing programs. The Bank of Japan, The European Central Bank, the Bank of China, as well as monetary authorities in Australia and Canada, have all taken steps to stimulate spending and investment in their domestic market. These low-interest policies have the additional effect of lowering the value of their currencies.
A true currency war would entail direct intervention by central banks in the market foreign exchange. The Swiss National Bank did try for some time to fix the Franc’s value against the Euro, but that program ended abruptly last month. There is no evidence central banks worldwide are actively buying and selling currency to push values lower against the dollar.
The strength of the dollar, or weakness of all the other major currencies, is evidence of the structural problems in much of the world’s economies.
Japan continues to struggle with a lack of consumer demand and burdensome labor market regulations. European finance ministers continue to fight against profligate government spending in Greece and other Eurozone member countries.
Meanwhile, China is exporting lower inflation to the rest of the world through subsidies to export-oriented industries. Officials there are trying to overcome their mistake of the government funded housing bubble. The economies of Australia, Canada, and Norway are reeling from lower commodity prices, especially in the oil market. But this trend is good for all of us. New technologies help us find more oil and other commodities more easily.
The large gap in the economic outlook between the US and the rest of the world can be seen in the bond markets.
Yields in the global bond markets are nearly 2 percent less than those in the US. Shorter-term bonds in much of Europe yield negative returns. Most recently, Sweden’s central bank lowered interest rates into negative territory and announced a new bond-buying program. The spread between 10-year US Treasuries and the German Bond yields is nearly 1.7 percent.
As economist Irving Fisher first formulated and explained a century ago, yield spreads differ for one of two reasons – real returns or inflation expectations. That is, the yield on one country’s bonds will be higher than another if either inflation is expected to be higher or the real, inflation-adjusted return is expected to be greater.
Fisher posited that real returns would not differ for very long. When investors see better returns after inflation in one country for any period of time they move capital from the lower real-return countries, equalizing the real return over time.
So right now, the real returns look better in the United States. The structural problems outlined above are driving capital out of those countries and into the US, driving up the value of the dollar. It will take some time, and perhaps a sharp drop in the value of financial assets across Japan, Europe, and elsewhere, but returns will equal out.
For the US investor this situation calls for patience and global diversification. Individual investors, and even professional money managers, should not try to beat the highly-volatile and competitive currency market.
For now, even the Fed can’t keep the dollar down. Over time, global financial markets will adjust.
The views expressed here are solely those of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.
Peter R. Crabb, Ph.D.
Professor of Finance and Economics
Department of Business and Economics
School of Business, Northwest Nazarene University
[email protected] and @prcrabb
Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado. His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others. Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho.
Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman.
Previous work experience includes international trade, banking, and investments.
 Retrieved February 13, 2015; http://www.wsj.com/mdc/public/page/2_3022-govtbonds.html?mod=mdc_bnd_gvtbnd