Interest Rates and the Dollar

By Reuters Staff
March 18, 2008

Why do lower interest rates depress the value of the dollar? And why should you care? Good questions worthy of a textbook-length response. I will try my best…..

First of all, it shouldn’t take much to convince you that you care about the value of the dollar. When its value declines that means, quite literally, that your dollars command less in terms of goods and services in the economy. Four years ago, one dollar purchased nearly a full gallon of regular unleaded gasoline. Today it buys only a quarter of a gallon…..

Now that you know you care about the dollar’s value, you may want to know some of the determining factors. One factor is interest rates. And the simple answer to the first question above–why lower interest rates depress the dollar’s value–is that lower interest rates for a currency reduce the incentive to save that currency.

Domestically-speaking, this rule means people have less incentive to park their money in a bank and more incentive to spend it. More spending means more dollars are floating around the economy. More dollars chasing a fixed number of goods will drive up the price of those goods (think Manhattan real estate: with so much Wall Street wealth floating around this island and only a fixed amount of land on it, real estate costs more here per square foot than anywhere else in the U.S.).

Internationally-speaking, the rule means investors have an incentive to move their money to countries where their savings will pay a higher rate of interest. So for instance, after today’s Fed rate cut, short-term U.S. savings will get an annualized rate of return between 2 and 3%. That’s down from over 5% less than 6 months ago. Compare that with the 4% rate of interest savers get in Europe right now. 4% interest vs. 2% interest. All else equal, investors with the option to save in dollars or in euros prefer to save in euros.

But how do those currently invested in dollars switch their savings to euros? How would you open a euro savings account if you only have dollars in your pocket? You simply exchange your dollars for euros, which you then put in a euro savings account. “Exchanging” dollars for euros is the same as “selling” your dollars for euros.

Remember that: SELLING dollars, BUYING euros. That’s the transaction that happens on foreign exchange markets when investors want to switch from “dollar-denominated” assets to “euro-denominated” assets.

Forgive me for repeating myself, but just so we’re clear:

If interest rates on dollar savings are going down, which they are, while interest rates on euro savings are staying the same, which they are, then it stands to reason that investors who have their savings in dollars would want to exchange them for savings in euros. To do that they have to sell dollars and buy euros. The demand for dollars is going down; the demand for euros is going up.

Here one need only recall the fundamental law of supply and demand: all else being equal, if demand for a commodity falls then so does the commodity’s price. The dollar is a commodity like any other and is subject to the same laws of supply and demand.

If investors increasingly demand euros instead of dollars for their savings accounts, then the value of the dollar will fall relative to the value of the euro. The chart below tracks the price of the dollar as quoted in euros since December 2005:

In December of 2005, one U.S. dollar purchased 0.86 euros, now it purchases 0.63 euros. The dollar buys 27% fewer euros today than it did just over two years ago.

Let’s add a complicating factor here: the trade deficit. What does the trade deficit have to do with the falling value of the dollar? Plenty. The most salient fact is that it turns America’s largest trading partners into some of the largest savers of dollars. Savers who have a larger incentive to shift their savings into higher-yielding euros each time the Fed cuts rates.

THE TRADE DEFICIT

Consider that every time an American imports a commodity from abroad he trades his dollars for it. For example, an American might trade $1 in exchange for a toy made in China. Or he could trade $109 for a barrel of oil dug from the ground in the Middle East. They get our dollars, we get their goods.

To help you, the individual consumer, appreciate exactly how YOU contribute to the trade deficit, it’s important to understand the middlemen who keep the process going. These middlemen buy goods from overseas, bring them back to the U.S. and then sell them to you. Walmart is a good example. To keep its prices so low, it searches out the lowest cost producers for all the stuff it stocks on its shelves, many of whom are located abroad. When you buy a toy at Walmart with a “made in China” label, the behemoth retailer is facilitating trade between you and a Chinese producer.

Again: you give the Chinese a dollar and get a toy in return.

Trade tends to be a two-way street. Most economies that sell goods to America also buy goods from America. And the mechanics are the same, just reversed. They give us currency, we give them American-made goods.

America has a trade “deficit” because we buy more foreign goods than foreigners buy American goods. $60 billion more per month to be exact. $2 billion more per day. That’s the net amount of cash we send abroad in exchange for goods and services. (Swedish massage anyone?)

Many foreign economies rely on trade with the U.S. in order to drive growth. It’s in their interest to keep the prices of their goods competitive in dollar terms so that American consumers keep buying them. To do so, foreign governments have to prevent their currencies from rising in value versus the dollar, which can be tough because the constant flow of dollars into their economies makes those dollars worth less.

To prevent their currencies from rising in value against the dollar, foreign central banks must mop up the flood of dollars flowing into their economies by purchasing them with their own currency.

In this and other ways, $2 billion a day finds its way into the savings accounts of foreigners and foreign governments.

And now we’re back to where we started: savings denominated in dollars….trillions of them in the vaults of foreign governments, which they turn around and invest in U.S. treasuries and mortgage-backed securities.

As the Fed cuts rates, it gives foreign governments an incentive to shift their savings into higher-yielding currencies.

Remember the basic relationship we specified above? As savers shift their savings into currencies other than the dollar, the value of the dollar falls relative to the currency into which they’ve converted their savings. This was because to effect the trade, the saver has to SELL dollars and BUY the other currency. Lower demand for dollars…..law of supply and demand….the dollar’s value falls. You’ve got it now.

But foreign countries that rely on trade with the U.S. to drive economic growth are loath to let the dollar fall since it would make their exports more expensive/less appealing to American consumers.

But at a certain point, some experts worry that the constant flood of dollars into their economies–combined with more Fed rate cuts that make those dollars less valuable savings vehicles–could cause certain foreign governments so much inflation at home that they have no choice but to let their currencies rise:

The inflation mechanics are as follows. The pegging central bank has to buy U.S. dollars in the foreign exchange market in order to prevent the dollar from falli
ng against its currency. The dollar-buying central bank purchases dollars with its own currency. The dollar-buying central bank gets its own currency the same way all central banks get their own currency – it figuratively “prints” it. The dollar-purchasing central bank therefore floods its economy with its own base money, resulting in inflation – inflation in the prices of goods/services and inflation in the prices of assets. [The above is often referred to in shorthand as the U.S. "exporting inflation."]

…in our opinion, what could turn a walk on the dollar into a sprint would be a decision by the Chinese and/or Saudi central banks to eliminate the pegs of their currencies to the greenback. Now, what would motivate these central banks to sever the peg? The desire to rein in their domestic inflation. In an environment in which the dollar is under downward pressure, the by-product of pegging one’s currency is higher inflation in the economy whose central bank is pegging.

It’s not exactly easy for a government with trillions of dollars in its bank to convert them quickly into other currency. So a “sprint” from the dollar by governments that hold them isn’t a high probability event. And yet it seems unwise for the Fed to tempt fate……

As we noted at the top, you care about a fall in the value of the dollar because that means you can’t buy as much stuff. A dollar is, after all, only worth what it will buy……

[Why in God's name would the Fed cut interest rates if it could cause a dollar stampede? Good question......but I'm tired so will save that one for another day.....]

………………
Read other posts on OptionARMageddon:

How ’bout some good news!

Capital Raising, Merrill trickery
Fannie/Freddie may need to raise MUCH more capital
A Great Society No Longer? Interview with GAO chief David Walker
Walking Away……
Sanity at last? Paulson rejects bailouts
CDS, a hedge-funder’s view
Baltimore Sun Op-Ed: Ron Paul calls it on Fannie and Freddie

Comments

Leverage works in odd ways. 100% financing…which many current greybeards used to finance their first home ofter WW2 or Korea, did not ruin the economy, nor will leveraged financing kill us this time. I am in the mortgage and RE industry, and I do not know one person who is in trouble with their mortgage due to leverage, ARM adjustments or housing value issues (unless they are forced to sell at this time)whose income has reamined stable or increased.The income problem we have is the single greatest issue facing the economy, and the recent success of housing has masked the fact that employers were not maintaining pace with the rest of the economy as far as the grouth wages is conserned.Now, as the mortgage guidelines tighten like a noose around the economic neck of the country, we need more effective dialogue, not finger pointing.

Posted by JohnP | Report as abusive
 

“Family conditions often outweigh market conditions.” Interesting. So they AGREE that market conditions probably suck in your area, but that nagging wives should trump financial logic. How to deal with this problem? Wifey-poo would probably agree that wiping out the family savings through a fall in home equity is worse than renting a house for another year.You forgot to mention the fact that in many areas including where I live rents are going up as people that are choosing to not buy are competing with people that must rent. Rents are up substantially year over year, at least here.

Posted by Jim | Report as abusive
 

When purchasing a home, always take a clue from the rental market. See how much the place would rent for. If the potential rent would cover the mortgage and then some (at least 40% more), then this is a good deal.But if the rent does not even come close to a regular mortgage, fugettabadit! The cost of owning a home over 20 years is about twice the mortgage payments. Trust me, I’ve been there.Of course, when the prices go up, the appreciation makes up for the extra cost big time. Plus, if you’re lucy, you’ll flip this place without having to pay the REAL cost of a home.But in this real world of today, don’t count on appreciation for the next 5 years. Look at the cold hard facts. A medium priced place that sells today for 300K instead of 400K in 2006 is still not cheap enough if the median income is 45K and would rent for only 1200. The numbers just do not add up.And forget about the “people will pay a premium just to own” mantra. Today a house is a safety piggy bank, a retirement plan, a health care back-up plan. Pride of ownership is now second to the investment nature of real estate.

Posted by Christophe | Report as abusive
 

“Homeowners benefit from the power of leverage. Over 10 years, a $10,000 investment in the stock market at a normal 10% market rate of return would yield $23,600. The same investment as a down payment on a $200,000 home at a normal appreciation rate of 5% would return nearly 5 times the stock market return, at $110,300.”Not so fast there NAR. $10,000 invested in an S&P500 index fund is “fire-and-forget”. You get your $23k without further investment.$20k as a down payment on a house is not the end of the story. You still have to pay off the $180k mortgage. For a 30-year loan that’s about $1260/month, plus property tax. After 10 years you’ve “invested” at least $150k more for that on-paper $110,000 gain.

Posted by Carlos | Report as abusive
 

Carlos, unless you live in mom and dads basement, you’re paying rent….say $800 x 12 x 10 yrs = $96,000. If you are making a living, the after tax cost(est 30%) of rent could be around $137,000….you would chase $23,000 like that…???I have yet to see an analysis which considers a complete picture, including the cost of renting, covering a 10 year ownership period, where home onwership does not beat renting.Jim, you are right on the rent increases…one of the reasons rent was low for this period was the expansion of home ownership.. Those who crossed the line to buy…the brave ones, created vacancies and helped to force rents down for those who could not muster the courage to buy.I have an FDIC study prepared in 2005. They study addresses the issue of boom and bust. The conclusions were that: 1) booms do not necessarily end in bust; 2)in the abcense of economic problems (Dteroit/auto) or natural disasters (Katrina, these economies stagnate; 3)The period of stagnation exists because home prices outstripped income growth and now income must catch up. 4) When income is inline with or exceeds housing cost, then price growth begins again….We are stagnated, or we would have been if the financial markets had remained stable. As long as the mortgage markets contract, there will be problems not anticipated by the FDIC study. The problems are getting far worse than they should have had the markets kept their composure.

Posted by JohnP | Report as abusive
 

1) Family conditions often outweigh market conditions.” Interesting. So they AGREE that market conditions probably suck in your area, but that nagging wives should trump financial logic. How to deal with this problem? Wifey-poo would probably agree that wiping out the family savings through a fall in home equity is worse than renting a house for another year.”Wifey-poo? Nagging wives? at first I assumed there must be something on the NRA page or ad to provoke this shockingly backward thinking gender bias, but there is not. Somehow you have concluded from the phrase ‘family conditions often outweight market conditions’ that women (specifically wives, perhaps yours?) are nasty harridans who have no financial sense. Nice. 2) I live in Los Angeles and regulary move to different neighborhoods about once a year to try them out. Rents are not going up. They have stayed level. Although that may be because folks are still deep in denial in this market.

Posted by brenda | Report as abusive
 

Responding to johnp, I’ve added links to the post to demonstrate the folly of buying vs. renting when the TOTAL cost of buying far outweighs the total cost of renting. Arguing that leverage hasn’t hurt people in the past ignores the obvious, that the market conditions in which we find ourselves, including the continued fall of prices NATIONWIDE and the unprecedented credit terms previously available to borrowers, make the present completely unique in the history of American housing.If, like johnp and the NAR, you have to rely on assumed “long-term” appreciation in order to justify taking a loss now then I still argue the prudent thing to do is wait.Responding to Brenda, you’re right. That particular paragraph was flip and backward-thinking. I thought my readers would understand that I was trying to be ironic, speaking in ridiculous generalities the way the NAR seems to do. But reading the paragraph again, I see it wasn’t written well enough to be seen the way I wanted it to be. Hence the change above.

Posted by RW | Report as abusive
 

JR…future appreciation is not an opinion…the fact is that over the past 40+ years housing has appreciated around 6.5% according to OFHEO….In our area, according to OFHEO stats, we gainded 78% in value on the past 5 years, and gave back 3.8% last year…these are facts…not guesses.Next fact is the rule of 7′s … 7 years on a job….7 years in a marriage…7 years in a home….these are norms. Those who bought a home in the 2001-2002 recession did very well…their 7 years is up this year or next. Those who bought on 2006, their 7 years is up in 2013. There is no evidence that they will not achieve a positive yield on their home onwership experience.As for the mortgage credit stranglehold currently exacerbating the housing market, this same knee-jeck reaction took place the late 80′s-early 90′s problems, when lending abandoned the market place. Had we maintained a more stable attitude towards lending, our problems would be greatly reduced.I have a client on the phone right now. His income is about to be cut by his employer…he works in a stone quarry and has had this job for 10+ years. His hours are getting cut 25%….next month..Is this a housing problem or an income problem?

Posted by JohnP | Report as abusive
 

RW, thanks for your response. I take responsibility for not giving you the benefit of the doubt. Your explanation of your ironic tone makes sense and I will read ‘between the lines’ in future!

Posted by brenda | Report as abusive
 

Take a look at johnp’s argument, it continues to rely on “long-term” results. And his argument that 40 years of data prove his point is specious because, as I said in my comment above, we are in the midst of a housing decline of unprecedented proportion. By definition, I think an “unprecedented” event is hard to fit into a box using “historical” data.Again, let me reiterate the core of my argument. Buying a home isn’t necessarily a bad idea. Buying a home NOW is a bad idea–unless you can get a big discount on the market price.Johnp notes in his first post above that he works “in the mortgage and RE industries.” It’s funny, the similarities between real estate professionals and investment professionals. People listen to them when they say you have to “stay invested for the long-term” because you “can’t beat the market.” Having spent a few years in the investment profession, I can speak for that one and say the guys who always say “buy and hold” often do so for two reasons.1. unfortunately, they don’t do a lot of real work to determine which stocks are actually a good value.But perhaps more importanly,2. they ONLY GET PAID if you “stay in the market.” Investment pros typically get paid fees based on the level of assets under management. Therefore they have an incentive to keep you invested at all times.Because the bottom line is that investment “pros” are actually SALESMAN. They get paid to sell you something, a stock or a mutual fund….making you money is also important, but SECONDARY.I suspect things are similar with real estate and mortgage professionals like johnp, who only get paid when house sales and loans actually close. These people are salesman. They’re out to make THEMSELVES money, not you. So when common sense says now is CLEARLY NOT a good time to buy, they have to fall back on sophistries like relying on the “long-term.” I would certainly grant you that you CAN make money in the stock market or in housing if you hold on for the long-term. But to MAXIMIZE your gains and to AVOID losses, first you have to buy assets (a stock or a house) at a good price.Look at two investors who have been ridiculously successful, Warren Buffett in stocks and Sam Zell in real estate. Sam Zell (aka Saltator Sepulcir, Latin for “grave dancer”) has made billions largely by buying AT THE RIGHT TIME. Same story with Warren Buffett, he would be the first to tell you that you only buy assets your comfortable owning over the long-term. But before that, he would say you have to buy that asset at a discount to its true value.Most of you would say, well you have to have some kind of special brilliance to be a Warren Buffett or a Sam Zell. Yes of course you do. But common sense is often enough to keep people from buying at the wrong moment. Who among you didn’t KNOW deep down that real estate was starting to get ridiculously overvalued back as early as 2004? You just have to stick to your conviction for the (seemingly interminable) period before which prices finally return to common sense levels.Same story with tech/telecom stocks circa 1997-1998. Wasn’t it hard to stay on the sidelines while fortunes were being made in 1999 and 2000, before the crash that you KNEW would come finally did?The people that lost fortunes were the ones that kept drinking the kool-aid.Buying and holding CAN BE a good strategy. But you first you have to mix a little common sense into the buying part of the equation.So, dear reader, I say to you ignore real estate/mortgage “professionals” who say you have to buy now. Your common sense is a better guide to smart investing, whether in the stock market or real estate.

Posted by RW | Report as abusive
 

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/
  •