Has the exchange rate reached an inflection point?

Has the exchange rate re

By ARIE TAL
October 29, 2009 16:04
2 minute read.

The US dollar (USD) has weakened this year versus most of its 16 major counterparts. The DXY index (dollar index spot) which tracks the USD against the currencies of the six major US trading partners fell by 5.85 percent since the beginning of the year and by 14.5 percent since March 5th. At the same time the Euro appreciated by 18 percent against the USD, and few days ago the exchange rate reached a level of 1.50 EUR-USD - a 14 months high. The tendentiousness did not skip the exchange rate of the USD and its Israeli counterpart. The USD fell against the Israeli Shekel (ILS) by 1 percent so far this year, and by almost 12 percent since reaching the 4.25 level on April 23rd. However, after reaching a level of 14 months low on October 21st against the major global currencies, the USD has started to show signs of strength. The greenback rose on average by 1.8 percent against its major counterparts and by 1.5 percent against the Israeli shekel. Due to this recent development the debates have started, where the most popular one is whether the recent strengthening of the USD signaling that the currency has reached a point of inflection and a stronger dollar is coming into play, or is it just a technical market correction? By definition, Inflection points are points where a curve or trends change directions significantly. This phenomenon should be supported by fundamental factors and should be evaluated over a reasonable period of time. Firstly, it is still early to assert that we have reached an inflection point after just five consecutive trading days. Fundamentally speaking, the picture is ambiguous. On the one hand there are reasons to believe that the USD will continue depreciating. The US budget deficit is in its historical peak and still rising due to descending tax revenue and large government spending that is aimed to support the relatively weak economy. The government continues to print money to finance both its spending and debt and by that it devalues the currency. In addition, the current account deficit is still high despite the slight improvement in the last months (the weakness of the dollar contributed significantly to this improvement). On the other hand, there are fundamental currents that support a cyclical appreciation of the dollar. First, there has been a rise in short-term inflation expectations which was followed by a modest firming of short-term US interest rates. Some observers are linking this to speculation that next week's FOMC statement may modify or drop the phrase about rates being exceptionally low for an extended period of time and the Fed's commitment to price stability. In addition, the treasury department is seeking to do everything it can to sustain confidence in the dollar after the currency was criticized worldwide. Third, depreciation of the dollar supports US exporters, but it harms exporters from other nations by making their goods and services less attractive. These opposing forces will definitely contribute to increase in volatility in the foreign exchange market, and as a result also in the stock market due to the high correlation between the two markets. Furthermore, it is too early to assess whether the recent appreciation of the dollar will continue. However, it is important to note that a change in tone of the Federal Reserve with regard to the exit strategy and its commitment to price stability may help setting a floor price to the US greenback. The writer is Chief Analyst and Strategist at Alumot-Sprint Investment House and also a regular writer for several leading financial papers and websites.


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