Dollar Gyrations

The US dollar early this week seemed to be on a slippery wicket, when it depreciated against major currencies. The currency depreciated as some improvement in the economic status was projected in terms of US pending home sales and a marginal increase in construction spending. While US pending home sales jumped 3.2% in March, construction spending increased 0.3%. At the same time there seemed to be some good news coming out of China, where the China Purchasing Manager Index firmed up to 50.1 in April from 44.8 in the previous month. An index level above 50 indicates expansion, while a reading lesser than 50 suggests contraction.

These indicators seemed to suggest that the economy was showing some signs of recovery. But we have a falling dollar in a strengthening economy. This contradiction is the result of a fall in risk aversion. The first sign of improvement in the economy sends investors rushing towards riskier instruments like stocks. This leads to investors diluting their dollar denominated secure holdings in US treasuries and buying other currencies for investing in various stock markets. Sale of dollars leads to a depreciation in the dollar versus currencies that are being purchased.

Well the dollar seemed to have recovered on the second day of the week on announcement of some bad news. This also seems to be a conflicting movement, but is can be explained in terms of the risk appetite equation. Any bad news leads investors to shed riskier assets and hide under the cover of safer US treasuries. This time around the news of the service sector contracting for the seventh straight months seems to egged the dollar up, though, the contraction was at a pace lower than previously.

However, a weak economy leading to a rise in the dollar and vice versa is a short term relationship. A currency of a nation can gain long term strength only if it is backed by a strong economy. Thus, investors may expect short term gyrations in the dollar based on the risk aversion explanation. But, in the long term, investors need to spot economic strength as the deciding factor for making investments. It may thus be advisable for investors to clearly differentiate between short term and long term positions of their investments. In the short term, investors must remember to track the movement of capital between dollar investments and riskier stock investments and make the most by following them.

The current position of the dollar, which seems to be driven up due to risk aversion is an over pumped dollar, artificially bloated by absorbing risk from around the globe. As this risk mitigates, the dollar will depreciate and move closer to its true value relative to other currencies. This could be the medium run direction of the dollar. Finally with the economy shaping up, the dollar could strengthen a bit and stabilize. However, in all this analysis, investors need to factor in the position of other economies as well, as the trading rate of a currency is relative to another currency, the value of which is determined by the economic strength of its underlying economy.