The dollar is recovering having suffered amid a global recovery according to Bank of Ireland

US economy performance and expectations on monetary tightening to become significant drivers

The US dollar has recovered some ground over the past few weeks following a pronounced depreciation since the spring. The US currency fell by an average 16% against the major currencies from its March high, with the New Zealand and Australian dollars rising by over 45% against the greenback over that period. The euro appreciated by 20%, rising from $1.25 to a high of $1.50 before falling back a little of late according to Bank of Ireland’s latest Bulletin which was published today, Friday 30 October 2009.

Author of the Bulletin, Dr. Dan McLaughlin, Group Chief Economist, Bank of Ireland said: “The factors driving currencies vary over time, making it difficult to disentangle short term speculatively-driven moves from more fundamental forces. In the dollar’s case, for example, traders have built up a significant short position in the currency against the euro, which ultimately will be covered, so eventually boosting dollar demand. The US currency certainly looks cheap against the euro in terms of purchasing power parity (PPP), a theory which posits that currencies adjust to reflect relative inflation differentials, with countries experiencing high inflation likely to see their currencies decline. Estimates of PPP vary but the OECD put the euro/dollar PPP at $1.18 implying a very significant overvaluation of the euro. A simple version of PPP, the Big Mac index, which uses the respective price of that meal across countries, points to an even lower euro/dollar PPP, of $1.05, although history suggests that currencies can depart from PPP for long periods.

“Proponents of a weak dollar often argued in the past that the scale of the US balance of payments deficit was dollar negative, although funding that deficit was never a big issue for the US. Moreover, the US BoP deficit has fallen sharply this year, to under 3% of GDP from 6% in 2006, yet the dollar is weaker now than it was then.

“Short-term interest rates in the US are lower than most other countries, of course, and this may be a factor hurting the dollar, but a bigger influence appears to be market appetite for risk. The dollar’s appreciation in the second half of 2008 (the euro/dollar rate fell from $1.60 to $1.25) was driven by risk aversion, it is argued, with investors seeking the perceived safety of US government bonds amid plunging equity markets. The dollar subsequently suffered as investors shifted back to riskier assets this year in anticipation of a global recovery. The dollar is negatively correlated with the US equity market, at present, falling if the S&P rises, lending support to the risk aversion view.

On that basis a dollar rally would be inconsistent with a further rise in equity markets but we suspect that the performance of the US economy and expectations about Fed monetary tightening will become more significant drivers of the US currency, particularly given the return to positive growth in the third quarter. Ultimately, currencies tend to reflect relative economic performance and it is not clear to us that the outlook for the US economy is worse than for the euro economy. Consequently, we still expect the euro/dollar to trade in a broad $1.40 to $1.50 range over the next six months”, concluded Dr. Dan McLaughlin.

Download November 2009 Bulletin

Ends

30 October 2009

For reference:

Dr. Dan McLaughlin
Group Chief Economist
Bank of Ireland Global Markets
Tel: 01 609 3221

Anne Mathews Media Relations Manager
Group Communications
Bank of Ireland
Tel: 01 604 3836