It's really very elementary, according to the presidents of the San Francisco and New York Federal Reserve Banks. The dollar is strong because the relative outlook for US growth exceeds that of other countries. That's all you need to know. No fancy theories needed.
Robert Parry, the chief of the San Francisco Fed, said Friday about the dollar: "It's almost a reflection in a mirror. It's a reflection of the relative performance of the US economy versus other economies."
New York Fed President William McDonough last Tuesday said in so many words that the dollar is strong because the US is a more attractive place to invest.
I love simple theories of foreign exchange because when they are right, they tell you how to trade. Foreign exchange is a thematic market, with traders focusing at any one time on a handful of topics or themes. For now, the theme is higher growth in the US or, alternatively, lower growth in Europe or Japan to boost the value of the buck.
The dollar is trading, and has been trading for some time, to the tune of the relative growth story. Take that story away -- say the economy is going into a slump -- and down will go the dollar.
Reinforce the story -- shout it from the treetops that American prosperity is back -- and down will go the euro and the yen.
Still, it is not so obvious how to interpret US Federal Reserve policy, or for that matter, the policy of the Bank of Japan or European Central Bank. The trick is to be able to separate policy initiatives from their implied reading on the economy.
Take the Fed's policy quandary right now. Suppose the Fed were to indicate it would soon raise interest rates. How would the foreign exchange market react? Since the theme is growth, the market could take it as good news or bad news.
The rate increase would be bad news because a higher interest rate would dampen investment and throttle growth.
Yet the fact that the Fed thinks the recovery is solid enough to start worrying about inflation would be good news because it speaks to a rosy forecast. Growth is in the cards, so why not buy the dollar? Competition among economies is the ultimate key to foreign exchange. This test is graded on a "curve," so to speak, wherein relative ranking is more important than absolute scores. It's not enough to grow, you have to grow faster. It's not enough to succeed, your competition must also fail.
So it is with currencies priced off of comparative growth.
And the dollar's competition is lagging.
For sure what McDonough and Parry said is mildly insulting to European prospects. Yet they could point to Europe's economy having shrunk 0.2 percent in the fourth quarter, the first decline in almost nine years.
And you can forget about Japan because, as they say, Tokyo doesn't have a dog in this fight.
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