The Expectations of the Dollar - Essay Example

___________ ____________ ____March 2006 The Expectations of the Dollar Proposition The dollar declined for a fourth day against the yen and Euro after a report showing slower-than- expected inflation eased speculation that the Federal Reserve will raise interest rates more than twice this year. The dollar has fallen more than 2 percent against the euro and more than 1.8 percent versus the yen the week ending Mar 16, the biggest drops since the week ended Jan. 6, after reports showed a record deficit in the U.S. current account and retail sales declined. Market opinions are afloat that we might be in a period of dollar weakness as present US data is supporting the notion the Fed will go only about one or two more times for increasing the interest rates' .This quite overlooks the fact that the Fed has raised its benchmark overnight lending rate 14 times since June 2004 to 4.5 percent from 1 percent, to prevent the economic expansion from overheating. Interest-rate futures demonstrate that the traders are certain the Fed will increase its benchmark to 4.75 percent on March 28, and predict about a 65 percent chance of another increase to 5 percent at the May meeting. However the outlook was not the same say in October 2005 when Fed was expected to go in for graduated dosages of increase in interest rate in keeping with the trend began since June 2004. The dollar had then risen 2.3 percent against the yen since the end of June 2005. The dollar ran its third straight quarterly gain, reported in October 2005, against the yen, the longest winning streak since 2001, as the Federal Reserve stuck to its policy of ''measured" increases in interest rates. The markets had then expected the dollar to rally to about 115 yens. The yield advantage of 10-year US Treasury notes with Japan had averaged 2.87 percentage points in 2005 year and reached as much as 3.27 percentage points on March 28 2005. As a result of these Japanese investors were buying the dollar to purchase overseas assets, such as Treasuries strengthening interest in dollar. As compared to this The Bank of Japan had kept rates near zero since 2001.US Rate increases had helped notch an 11 percent gain in the dollar vs. the yen. However for the first time ,in this scenario Bank of Japan indicated that the yen may be supported by indicating a timetable for ending its policy of holding interest rates near zero.BOJ had also decided to stop pumping money into the economy and to recommence forecasting of inflation after a seven-year absence. The risks to the US dollar in 2006 are being widely debated. Last year too Bill Gates, Warren Buffett and George Soros had predicted a crash of the US dollar which, however, did not materialize. However sufficient arguments exist today on why the US dollarwill stopdefying gravity and fall this year. As stated abovein the last few weeks the dollar has kept on falling relative to the Euro and Yen, as expectations of relative short term interest rate differentials and growth rates are turning against the U.S. US slow down, which may or may not trigger global slow down, is quite a probability with risks of a disorderly adjustment triggered by the bursting of the US housing bubble and the stagflationary effect of another oil shock driven by supply tightness and a confrontation with Iran. Moreover a large trade deficit of 7% of GDP has led to an unsustainable accumulation of net foreign liabilities (Roubini, 2006). These combined with domestic slowdown leave out weak signals for dollar with slight corrections in or around the two expected step-ups. This outlook would run concurrently to the period required to smoothen out these imbalances. This is expected to last the entire of the remainder portion of 2006 at the least. Theoretical Setting Post Bretton Woods period was a period of fixed exchange rates and primary forex market analytics concerned the effects of discrete policy induced changes in the level of exchange rates-be it a devaluation or appreciation. National economies and the global economy as result had segmented capital markets with limited international capital flows. The exchange rates' analysis was essentially trade related and its impact on balance of payment the primary object of any such analysis. Exchange rate was an exogenous variable and affected the endogenous variable of current account balance. Advent of floating exchange rates shifted attention of market analysts to determinants of exchange rates. Several theoretical constructs have been developed to explain the movements in exchange rates. Several important macro economic variables features, drawn from a fast changing global markets, have found place of prominence in such theoretical constructs. Main among such variables are current account balances, levels of monetary growth, inflation differentials, interest rate differentials, capital flows and asset composition, expectations, news etc. The classical construct of exchange rates is that of purchasing power parity. It simply states that a standard basket of goods can be sold for differing numbers of currency units in two different jurisdictions. Ratio of the units of these two different currencies sets the exchange rate. Assumption is that goods markets are perfect globally. In such a case ratio of purchasing power of two currencies determines the exchange rate between these two currencies. This is absolute purchasing power parity. A relative purchasing power parity version simply states that over any two points of time exchange rate differentials near about equals the inflation differentials in two jurisdictions over the same period of time. Flow equilibrium models simply determine equilibrium rates of a currency depending upon its demand and supply. This is primarily explained by derived demand and supply of currency from export/import of goods between two countries and entirely focuses on current account transactions ignoring capital account entirely.Mundell -Fleming model incorporates capital inflows which, in turn, are taken as dependent on interest rate differentials between two jurisdictions. However this model is based on the weak assumption of fixed domestic prices. Asset market models on the other hand emphasize that equilibrium exchange rate is that rate at which the market as a whole is willing to hold the given stocks of assets denominated in different currencies. According to these theories forex market is like any other organized financial market. One model 'The Current Account Monetary Model simply asserts that residents in any jurisdiction corrects a discrepancy between the stock of money they wish to hold and that created by monetary authority by having a surplus or deficit balance of payments. In case of excess actual supply residents spend it on domestic goods and import foreign goods. A reverse happens when the actual supply is less than demand. This results in pressure on domestic price levels and results in depreciation/appreciation of the exchange rate.Frankel Model, a Capital Account Monetary Model predicts that an increase in money supply will depreciate the exchange rate in the long run while an increase in real income will result in an appreciation. The effect of an interest rate increase will depend upon whether it is caused by "monetary tightness" or by an expectation of increasing inflation. Tightness leads to domestic currency's appreciation while expectations lead to depreciation (Frankel, 1979). Monetary Models ignore all other assets except money. These models assume that domestic and foreign financial assets' markets clear. In sharp contrast to these Portfolio Balance Models posit asset choice as a portfolio diversification problem and given total wealth we have investors diving it into various assets-domestic and foreign(money, bonds etc) based on their expected returns given that differently denominated assets are not perfect substitutes. In case of an open market(OM) sale of government bonds an appreciation of exchange rate takes place via media two sources decrease in domestic currency supply raises its price vis a vis foreign currency and increase in supply of government bonds reduce their prices and thereby increase domestic interest rates. A reversal takes place in case of OM purchase of government bonds. Similarly in case of increase in real income domestic savings increase which pulls up demand for domestic bonds than for foreign bonds. As a result domestic bond prices rise in comparison to foreign bonds. This makes domestic interest rates to fall more than the foreign interest rates causing investors to switch from domestic to foreign bonds depreciating the currency. Another theory is based on Efficient Market Hypothesis which considers foreign currency as a continuously traded (spot) durable asset with little storage value. Here investors behave rationally and current quotes reflect all of the information about the market. In case any new information is expected then price may fluctuate to a new level or else here would be opportunities for abnormal profits. Here expectations about news, more so about current fundamentals can make the prices react sharply. This also explains why the spot rates behaved the way did. Connecting theory to practice Presently most jurisdictions follow floating exchange rate regimes which they softly manage to meet national objects. Information technology, gradual liberalization of goods and financial markets coupled with financial innovation and improving supervisory and regulatory standards have ensured the world economy to shrink. We have short term cross border hot money/capital flows chasing returns (interest rate differentials).These have ensured substantial creation of competitive behavior and currency markets have been no exception. In line with theories stated above we have had several past events affecting the ultimate fate of US dollar. These are quoted below just to draw the link between the stated theories and observed market behavior. The expectations regarding US interest rate changes and the US slow down, as discussed above, clearly draws parallel in all of the theory stated above. A lower than anticipated interest rate differential between the US and the Japan made the dollar to fall with gravity against the yen. A US slow down whenever expedited would increase the money supply and depreciate the exchange rate. The euro has shown some strength and people have jumped on board,'' said Grant Wilson, a currency trader at Mellon Financial Corp. in Pittsburgh. Interest rates are driving the market right now. The spreads against Europe are getting closer. They've really compressed in the last month or so'' (Dollar, 2006). "Demand for the U.S. currency may be sustained as signs of an expanding economy add to evidence that the Federal Reserve will keep raising interest rates into next year. Higher yields in the U.S. relative to Europe and Japan may spur buying of dollar- denominated bonds"(Goto, 2005). The above two situations provide clear views of dollar loosing ground and gaining ground with vital reasons specifically stated alongside. In the end we can perhaps surmise as," the factors that market practitioners take into consideration have changed over time, and on the whole they have multiplies almost beyond our calculations. In the early days of the floating regime, we thought that medium and long-term elements such as purchasing power parities and balance of payments adjustments would still have major influence. But then short-term capital flows and interest differentials became very important. But aside from that, there was the explosion of information technology, which promoted quick shift of focus. One moment the market will be focusing on interest rates, the next on balance of payment data, and then on political developments. So it is difficult to pinpoint decisive factors in short-term movements. Recently I was talking to one of Japan's best foreign exchange dealers, and I asked him to name the factors he considers in buying and selling. He said," Many factors, sometimes very short term, and some medium, and some long-term." I became very interested when he said he considered the long term and asked him what he meant by that time frame. He paused a few seconds and replied with genuine seriousness." Probably ten minutes". That is the way the market is moving these days"(Gyohten et al, 1992). Conclusion US dollar was expected to register a fall alongside gravity at the commencement of the year 2005.Dollar however belied all expectations and gained robustly against major currencies like Euro and Yen till up to last quarter of 2005.Reasons were simple enough and sourced in interest rate differentials. US had raised interest rates fairly regularly in this period raising the borrowing cost, supported by low unemployment figues, robust industrial production statistics and growing yield spread over German, Euro and Japanese the interest in dollar remained high and dollar registered gains. However a stagflationary slow down of US economy plagued further by housing bubble burst and massive fiscal and current account deficits signaled that interest rates could no longer be raised as freely as they were in the past. The US yield spreads came under pressure as Euro zone chased such spread with their own increase and Japan exhibited clear intent of moving away from zero interest rate. The US slow down may not be an easy affair to handle with long standing structural imbalances on fiscal and trade fronts to be tackled; hence outlook for US dollar remains strictly parallel to fortunes of US economy in getting out of slow down/stagflation/fiscal deficits/trade deficits. This can be a year at the least. Works Cited Roubini Nouriel,Global Economics Blog .Global Imbalances, the US Dollar and Globalization Challenges at Davos', Created: Jan 27 2006,Retreived March 28,2006 http://www.rgemonitor.com/blog/roubini/current_account_and_exchange_rates/ Frankel,J.On the mark:ATheory of Floating Exchange rates Based on Real Interest Differentials. American Economic Review, 69.pp 610-22.1979 Dollar Falls Against Euro and Yen as U.S. Inflation Is Less Than Forecast .2006. Retreived March 28,2006 http://www.bloomberg.com/news/markets/currencies.html Goto, Kosuke.Dollar Gains Versus Yen on U.S. Growth Outlook, Interest Rates.2005. Retreived March 28,2006 http://www.bloomberg.com/apps/newspid=10000087&sid=aaKAzYABNLOg&refer=top_world_news Gyohten,Toyoo in Volcker,P & Gyohten,T.Changing Fortunes:The World's Money and the Threat to American Leadership.Times Books.New York.1992. Read More