The dollar's value can be measured by three methods: exchange rates, Treasury notes and foreign exchange reserves (the amount of dollars held by foreign countries). These three measurements have recorded a rise in the dollar's value since 2011, reversing a downward decline that began in 2002. Here's why:
- The U.S. debt is more than $17 trillion. Foreign holders of this debt should be concerned that the U.S. will let the dollar value decline so the relative value of its debt is less.
- The large debt has forced the U.S. to both raise taxes and slow spending through sequestration. This has dampened economic growth, which should send the dollar's value down.
- As the European Union struggled to resolve the Greece debt crisis, it weakened demand for the euro. This strengthened the dollar.
- The dollar became a safe haven during the recession. As a result, foreign investors reversed a long-term trend to diversify their portfolios with more non-dollar denominated assets.
The Dollar Value Is Measured by Exchange Rates:
The U.S. dollar is most easily measured by its exchange rate, which compares its value to other currencies. Currency exchange rates allow you to determine how much of one currency you can exchange for another. Exchange rates change every day because currencies are traded on the foreign exchange market, known as forex. A currency's forex value depends on a lot of factors, including central bank interest rates, the country's debt levels, and the strength of its economy. When these are strong, so is the value of the currency.
Most countries allow their currencies to be determined by the forex market. This is known as a flexible exchange rate. Find out the dollar's value compared to the rupee, yen, Canadian dollar, and the pound in U.S. Dollar Rate.
Dollar Value Compared to Euro:
- 2013 - The dollar lost value against the euro, as it appeared the EU was finally solving the eurozone crisis. By August, the euro was worth $1.33.
- 2012 - By the end of 2012, the euro was worth $1.3186 as the dollar weakened.
- 2011 - The dollar's value against the euro fell 10%, then regained ground. As of December 30, 2011, the euro was worth $1.2973.
- 2010 - The Greece debt crisis strengthened the dollar. By year end, the euro was only worth $1.32.
- 2009 - The dollar fell 20% thanks to debt fears. By December, the euro was worth $1.43.
- 2008 - The dollar strengthened 22% as businesses hoarded dollars during the global financial crisis. By year end, the euro was worth $1.39.
- 2002-2007 - The dollar fell 40% as the U.S. debt grew 60%. In 2002, a euro was worth $.87 vs $1.44 by December 2007. (Source: Federal Reserve, Exchange Rates)
The Dollar's Value Is Measured by Treasury Notes:
The dollar's value is usually in sync with demand for Treasury notes. The Treasury Department sells notes for a fixed interest rate and face value. Investors bid at a Treasury auction for more or less than the face value, and can resell them on a secondary market. High demand means investors pay more than face value, and accept a lower yield. Low demand means investors pay less than face value and receive a higher yield. That's why a high yield means low dollar demand -- until the yield goes high enough to trigger renewed dollar demand.
- 2013 - The dollar weakened slightly, as the yield on the benchmark 10-year Treasury note rose to 1.88% by August. (Remember, high yields means a weak demand for Treasuries and dollars.)
- 2012 - The dollar strengthened significantly, as the yield fell in June to 1.443% -- a 200-year low. The dollar weakened towards the end of the year, as the yield rose to 1.78%.
- 2011 - The dollar weakened in early spring but rebounded by the end of the year. The 10-year Treasury note yield was 3.36% in January, rose to 3.75% in February, then plummeted to 1.89% by December 30.
- 2010 - The dollar strengthened, as the yield fell from 3.85% to 2.41% (January 1-October 10). It then weakened due to inflation fears from the Fed's QE2 strategy.
- 2009 - The dollar fell as the yield rose from 2.15% to 3.28%.
- 2008 - The yield dropped from 3.57% to 2.93% (April 2008-March 2009), as the dollar rose.
- Prior to April 2008, the yield stayed in a range of 3.91%-4.23%, indicating a stable dollar demand as a world currency. (Source: U.S. Treasury, Daily Treasury Yield Curve Rates)
The value of the dollar, whether measured by exchange rates or Treasury yields, will be undermined by the $17 trillion U.S. debt in the long run. However, during the recession, investors wanted a safe investment, which strengthened the dollar. The Fed's quantitative easing program kept interest rates low, which monetized the debt. The dollar also benefited from a temporary flight to safety, as investors worried about the outcome of the 2012 Presidential campaign, the fiscal cliff in 2012 and the government shutdown in 2013.
Value of the Dollar as Measured by Foreign Currency Reserves:
The dollar is held by foreign governments in their currency reserves. They wind up stockpiling dollars because they export more than they import. They receive dollars in payment. Many of these countries find it's in their best interest to hold onto dollars because it keeps their currency values lower. Some of the largest holders of U.S. dollars are Japan and China.
As the dollar declines, the value of their reserves also declines. As a result, they are less willing to hold dollars in reserve. They diversify into other currencies, such as the euro or even the Chinese yuan. This reduces demand for the dollar, putting further downward pressure on its value.
As of Q1 2013 (most recent report), there was a record $3.764 trillion in foreign government reserves held in dollars. However, governments are diversifying, as this represents only 62% of the total measurable reserves, down from 67% in Q3 2008. Since the percentage of dollars is slowly declining, this means that foreign governments are slowly moving their currency reserves out of dollars. In fact, the value of euros held in reserves increased from $393 billion to $1.432 trillion during this same time period, despite the eurozone crisis. Nevertheless, the holdings of the euro is still less than half the amount held in dollars. (Source: IMF, COFER Table)
How the Value of the Dollar Affects the U.S. Economy:
When the dollar declines, it makes American-made goods cheaper and more competitive when compared to foreign-produced goods. This helps increase U.S. exports, boosting economic growth. However, it also leads to higher oil prices in the summer, since oil is priced in dollars. Whenever the dollar declines, oil producing countries raise the price of oil to maintain profit margins in their local currency.
For example, the dollar is worth 3.75 Saudi riyals. Let's say a barrel of oil is worth $100, which makes it worth 375 Saudi riyals. If the dollar declines 20% against the euro, two things happen. First, the value of a barrel of oil has declined 20% to the Saudis. Second, the value of the riyal, which is fixed to the dollar, has also declined 20% against the euro. To purchase French pastries, the Saudis must now pay more than they did before the dollar declined. To avoid this, the Saudis raise the price of oil, which they do by threatening to limit supply. You notice this when you pay more for gas each week. Find out more ways it affects you in The Value of Money.
The growing U.S. debt weighs in the back of the minds of foreign investors. That's 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.