What causes volatility in the U.S Dollar?

The strength and weakness of currencies are generally assumed to follow trends in supply and demand, and the United States dollar should be no different. Since at least the middle of the 20th century, however, the dollar has held a special status around the globe as a reserve currency. This means that individuals, companies and governments have carried out international trade and held their capital reserves in dollar-linked accounts.

THE “ALMIGHTY BUCK”

The dollar’s position as a reserve currency can be traced to the period after the establishment of Federal Reserve Bank system in 1914 and the growth of U.S. trade around the world following WWI. Its position as a premier reserve currency was consolidated after WWII with expanded U.S. global trade.

Over time, that role was reinforced by the widespread perception that the U.S., backed by a stable institutional and political environment, is an economy that provides ample liquidity and a safe haven for investment from around the globe. This has given rise to an abundance of dollar trade outside the borders of U.S. territory known as the “eurodollar” market, which has amplified the global implications of U.S. policy moves and economic indicators.1)

As a reserve currency, the dollar historically has benefitted from particular stability in relation to many of its counterparts. However, even the dollar suffers from bouts of volatility. These are frequently in reaction to global geopolitical and economic events of “seismic” proportion, or events within the U.S. economy itself.

The dollar’s status as a reserve currency is directly related to the U.S. government’s commitment in the past several decades to a so-called “strong dollar policy,” which aims to maintain the dollar at a relatively stronger level in relation to its counterparts. The policy has the effect of making imports less expensive for U.S. businesses and consumers, and exports more expensive for potential buyers abroad. It is also thought to encourage foreign investors to buy U.S. financial assets and reinforce the dollar’s importance in global finance.2)

 

MONETARY POLICY

The dollar, like nearly all U.S. assets and many foreign assets, has shown special sensitivity to monetary policy from the U.S. Federal Reserve. The institution influences yields of U.S. treasury bonds, other securities traded in U.S. markets, and even securities traded abroad.

Additionally, monetary policy can affect the long-term prospects for activity and growth in the economy that influences revenues, earnings and dividends. As such, it is common for investors and the dollar rate to react, often in real time, to news and announcements related to interest rates and interest rate policy. These include events such as statements by Federal Reserve officials and the minutes of the Federal Open Market Committee (FOMC), where hints about future interest rate policy are thought to be revealed.

Monetary policy influence on the strength of the dollar was particularly evident over the past decade, when the Federal Reserve lowered interest rates to historic lows. This initially prompted a weakening of the dollar around the globe as investors moved their money to higher returns in assets abroad. The weakening trend was reversed later, however, when the Fed signaled it would once again raise rates, and investors from around the globe began to shift funds back to assets in the U.S. in pursuit of increasing yields.3)

ACTIVITY DATA

Researchers have found that the dollar exchange rate reacts to data that can affect future monetary policy, as well as the prospects for U.S. economic activity itself. Studies by independent economists and by the Federal Reserve have shown that volatility of the dollar rate against other currencies increases around the release of a series of key economic indicators, such as GDP figures, consumer confidence, construction spending, inflation figures, durable goods orders, industrial production, manufacturing data, payrolls, new home sales, retail sales, the trade balance and unemployment figures.4)

NON-DATA EVENTS AND OTHER INFLUENCES ON THE DOLLAR

In addition to undergoing influence from regular data releases, the dollar rate is occasionally influenced by world events and other factors that can affect the prospects for the U.S. economy. These may include news about global policy movements from world leaders and important international organisations, reports of conflicts between groups or governments in hotspots around the globe, or news of political or military power shifts in key economies.

The dollar rate can also be affected by significant corporate news, such as earnings, sales or employment reports from large companies that are deemed by investors to foretell the prospects for given sectors or for the economy as a whole.5)

 

 

 

COMMODITY AND OIL PRICES

Major moves in commodities and oil prices have also been found to have influence on the dollar rate.

Oil takes on particular significance among commodities for its effects on the U.S. economy and the dollar exchange rate. The U.S. economy is heavily dependent on oil. In 2014, oil use alone accounted for about 4% of the U.S. gross domestic product. The U.S. has been increasing its production of oil through development of shale oil reserves, but until recent years it had imported as much as 40% of its oil supplies for use as fuels in transportation and industry.6)

Data analysed by the Federal Reserve has shown that a 10 percent increase in the price of oil is associated with a drop of about 1.4% in the level of the U.S. real GDP.7) Further, increases in the cost of oil have been shown to promote increases in the costs of other commodities, making imports of needed materials for U.S. industry more expensive. The exact correlation between oil prices and dollar volatility, however, is not always clear.

Analysts point out that oil is generally priced in dollars around the globe. Thus, while supply and demand factors affecting the price of oil may have an impact on the dollar rate, the dollar rate itself may exert its own strong influence on the price of oil.8)

TRACKING VOLATILITY: HEAT WAVES OR METEOR SHOWERS?

Regardless of its source, traders can further try to prepare for volatility by watching possible extreme movements of the dollar against other currencies. While random global events may be difficult to track, volatility often occurs surrounding the release of key economic data and at off-peak trading hours—early morning and early evening when investors try to position themselves amid periods of low volume for possible unexpected upcoming events or market movements.

Traders may also want to keep an eye on geographic and intermarket trends. Some studies have suggested that rather than following a “heat wave” pattern where volatility remains isolated in individual markets, it often follows a “meteor shower” pattern, spilling over from one market to the next in a movement of contagion.9)

Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. Finance Administratorswill not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.

 

The first half of 2018 was an eventful one on the geopolitical front. International issues such as the Brexit transition process, denuclearisation of the Korean Peninsula and an escalating U.S.-China trade war made headlines on a near-daily basis.

Each event brought uncertainty to markets around the world, including the forex. Perhaps none has a potentially greater global impact than the economic standoff between the U.S. and China.

 

 

 

HOW DOES A TRADE WAR IMPACT CURRENCY?

A trade war is an ongoing dialogue between two nations in which each tries to undermine the economic prowess of the other. Viewed as a product of protectionism, trade wars are conducted by implementing tariffs and duties on specific imports.

The international trade war that ensued during the Great Depression era is a prime example of this event in action. In the wake of new and aggressive tariffs, world trade plummeted by 25% for the period.1) As a result, economies around the globe crumbled under rising debt and collapsing domestic currencies.

One phenomena associated with trade wars is currency devaluation. In order to mitigate the pressure felt on the export sector, it’s common for trade war participants to devalue their domestic currencies. This helps offset the negative effects of increased tariffs on goods and services, preserving marketshare of exports abroad.

A modern example of this activity can be found in Japan. Named after Prime Minister Shinzo Abe, the fiscal policy known as “Abenomics” promotes a program of aggressive quantitative easing and negative interbank lending rates.2) The results have been positive for Japan’s equities markets, but critics cite this practice as being rampant currency manipulation.3)

In the case of the U.S.-China trade war, devaluation came front-and-centre in late July 2018. In the midst of tariff announcements from both sides, the People’s Bank of China set the reference rate for the yuan renminbi (CNY, RNB) to 6.7671 CNY to the United States dollar(USD). The action represented an instantaneous 0.9% drop from previous levels.4) Shortly after the move, U.S. President Donald Trump expressed his concerns in a 20 July 2018 Tweet:

“China, the E.U. and others have been manipulating their currencies and interest rates lower, while the U.S. is raising rates and the USD gets stronger — taking away our big competitive edge. As usual, not a level playing field…”5)

Shortly after the tweet was sent, the USD Index fell more than 1%.6) The tit-for-tat trade war posturing impacted both the CNY and USD negatively, as investors anticipated forthcoming devaluations of both currencies.

 

THE BREAKDOWN OF U.S.-CHINA RELATIONS: OPENING SHOTS OF A TRADE WAR

On the Presidential campaign trail of 2016, then-Republican candidate Donald Trump used strong rhetoric to define his position on U.S.-China trade. Citing a 2016 deficit for the U.S. of more than US$300 billion,7) Trump pledged to decrease the liability through mass renegotiations with China if elected. This campaign promise was put on the front burner in 2018 with an initial volley of tariffs against Chinese imports.

The following is a timeline of key events for 2018 that contributed to U.S.-China trade hostilities:

 

(*Make a Table to put in all these event)

Date Event
3 March U.S. tariffs are enacted against all steel and aluminum imports.
22 March U.S. proposes extensive tariffs in response to China’s “unfair trade practices.”
23 March China reveals plans for tariffs on US$3 billion of U.S. imports.
2 April China threatens to levy duties on fresh fruits, nuts, wine and pork.
3 April U.S. announces tariffs on US$50 billion worth of technology imports.
4 April China announces plans for 25% duties on 106 U.S. imports, including soybeans, chemicals and aircraft. China also files a complaint against the U.S. at the World Trade Organisation (WTO).
5 April U.S. President Trump issues statement calling China’s tariffs “unfair retaliation.” An additional US$100 billion in tariffs are proposed.
17 April China enacts tariffs on sorghum imports worth US$1 billion.
3 May Trade talks in Beijing break down.
20 May An agreement is reached; the U.S. pledges to postpone tariffs and China offers to significantly increase the purchase of U.S. goods.
29 May U.S. announces plans to enact tariffs on US$50 billion of Chinese imports.
19 June U.S. President Trump suggests tariffs on US$200 billion in Chinese exports, with another US$200 billion possibly to follow.
6 July U.S. Tariffs on US$34 billion of Chinese imports go into effect.8)

 

 

The budding U.S.-China trade war has a great potential to upset the relative calm of global markets. Their two-way trade is estimated to be worth more than US$640 billion annually,9) a titanic figure.

In the event that new tariffs involving hundreds of billions of dollars go into effect, this relationship will evolve dramatically. From agriculture to technology, industries are likely to be negatively affected as producers and corporate interests on both sides jockey for survival.

In short, a disruption of the existing U.S.-China trade relationship has the potential to redefine international economics. Consequences will be exchange rate volatilities in addition to an intensive revaluation of global currencies.

UNITED STATES DOLLAR: PRE-TRADE WAR PERFORMANCE FOR 2018

In spite of constant economic sabre rattling, the first and second quarters of 2018 featured a strengthening USD. For the first half of 2018, the USD posted gains against all major currencies except the Japanese yen (JPY).

Amid two first-half rate hikes from the United States Federal Reserve (Fed) and two more proposed by the end of the calendar year,10) the USD exhibited a monthly uptrend. In addition, the U.S. economy showed robust growth for the period with 4.1% GDP11) and 3.9% Unemployment.12)

The reasons behind the USD’s strength for Q1 and Q2 2018 are debatable. However, a tightening of monetary policy from the Fed and robust economic performance are two undeniable drivers of value.

TRADE WAR FALLOUT: IMPACTS ON THE USD

The fallout from a prolonged U.S.-China trade war on the USD will be substantial. While the risk of devaluation is very real, it is difficult to fully account for the peripheral factors involved in the global currency trade.

No matter which side of the fence one is on—bullish or bearish—the USD is certain to be impacted in the following ways:

  • Periodic Volatility: As announcements for new tariffs or the enactment of existing ones becomes public, short-term volatilities will plague the USD.
  • Fed Policy: The largest drivers of the USD’s value are actions taken by the U.S. Fed. Increases to the federal funds rate limits inflationary pressures created by robust economic performance, promoting monetary strength. Future plans include raising the federal funds rate four times in 2018, to 2.5% by year’s end.13)
  • Possible Devaluation: While unlikely, it is possible that the USD could be devalued in the spirit of promoting economic growth. This scenario becoming a reality depends on the U.S.-China trade war producing an extended and devastating global economic impact. In the event the U.S. enters a recessionary cycle, weakening the USD is one course of action that can jumpstart a stagnant economy.

When it comes to the U.S.-China trade war, the USD is all but assured to experience spikes in periodic short-term volatilities as key events unfold. In the long-term, performance of the USD will depend on U.S.-global economic performance, actions of the U.S. Fed and the adopted monetary policies of central banks around the globe.

SUMMARY

Projecting the impact of a trade war on the domestic currency of a participant is always tricky. Negotiations are ongoing and new strategic alliances are formed on a regular basis.

It is important to remember that although a U.S.-China trade war is daunting on many fronts, it is a fluid situation. As conversations continue, it’s clear that both sides are interested in preserving their economic prowess. In the event that these economies experience a significant downturn, a cease-fire may come in short order.

Any opinions, news, research, analyses, prices, other information, or links to third-party sites contained on this website are provided as general market commentary and do not constitute investment advice. The market commentary has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and it is therefore not subject to any prohibition on dealing ahead of dissemination. Finance Administratorswill not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.