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Value of the U.S. Dollar

From Kimberly Amadeo,
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Value of the U.S. Dollar Compared to Other Currencies: The U.S. dollar is most easily measured by its exchange rate, which compares its value to other currencies. For example, on March 3, 2008, a Euro was worth $1.58. The dollar has declined in 40% value in the last six years, when a Euro was only worth 87 cents. (Source: Federal Reserve Bank of New York, Historical Exchange Rates)

Exchange rates change every day because currencies are traded on an open market. The demand for the dollar has declined against the Euro for many reasons:

  1. Interest rates in the U.S. are declining rapidly while those in Europe are declining more gradually.
  2. Fear of recession in the U.S. means investors are looking for non-dollar denominated investments.
  3. As more countries join or trade with the EU, demand for the Euro increases.
  4. As the dollar declines, investors are less likely to hold assets in dollars until the decline stops.
  5. Many investors are concerned that the large U.S. debt and current account deficit means the U.S. may let the dollar decline so the relative value of its debt is less.
Value of the Dollar as Measured by Treasury Bonds: The value of the dollar is also measured by the demand for U.S. Treasury Bills, Notes and Bonds. Treasury bills, notes and bonds are sold at auction by the U.S. Treasury Department and can be bought for more or less than the face value, depending on demand. They can also be resold on the open market, and the price can fluctuate further. The greater the demand, the lower the yield that the Government has to pay investors. Therefore, if the demand for the dollar falls significantly, then the yield paid on Treasuries should increase just as much.
In fact, the yield has declined. As of March 3, 2008, the 10-year Treasury Note yield was 3.54%, down 30% since March 4, 2002 when the yield was 5.02%. This means that the demand for the dollar-denominated Treasury notes is as strong as ever. (Source: U.S. Treasury, Daily Treasury Yield Curve Rates)
This is partly because in 2002, the world was coming out of a global recession, and investors were more interested in buying stocks than Treasuries. Now, the world may be going into a recession, and investors want a safe haven. If investors were very concerned about a dollar collapse, they would not be buying U.S. Treasuries.
Value of the Dollar as Measured by Foreign Currency Reserves: The dollar is also held by foreign governments who have an excess of cash, held in foreign currency reserves. This excess happens when countries, such as Japan and China, export more than they import. If these countries were concerned about the declining dollar, there would be a decline in the percentage of reserves held in dollars.

In fact, as of Q3 2007, there was at least $2.4 trillion of foreign government reserves held in dollars. This represents 63% of total measurable reserves. This is double the $1.2 trillion held in Q3 2002, when dollars comprised 68% of measurable reserves. Since the percentage of dollars is slowly declining, this means that foreign governments are slowly moving their currency reserves out of dollars. In fact, Euros held in reserves increased from 393 billion to 1 trillion during this same time period. (Source: IMF, COFER Table)

How the Value of the Dollar Affects the U.S. Economy: As the value of the dollar declines, it makes U.S. produced goods cheaper and more competitive when compared to foreign produced goods. This helps increase U.S. exports, and U.S. manufacturers, which is good for the economy. However, it also increases inflation, as the prices of imported goods increases. This is especially true for oil, which is priced in dollars. Oil producing countries will keep raising the price of oil to maintain profit margins in their local currency.
Normally, a declining dollar as measured by exchange rates would mean lower demand for U.S. Treasuries, which would lead to higher interest rates. However, when the world is facing a potential recession, U.S. Treasuries are still one of the safest investments around. That explains why the value of the dollar as measured by Treasury yields and foreign currency reserves has not declined. Low Treasury yields mean lower mortgage rates, which will help the U.S. housing market, and that is also good for the economy.
However, the $8 trillion U.S. debt is weighing in the back of the minds of foreign investors. That is why they may continue to gradually move out of dollar denominated investments - slowly, so they don't diminish the value of their existing holdings.

The best protection for an individual investor is a well-diversified portfolio that includes foreign mutual funds.
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