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The US dollar has increased in value by almost 25% over the past year and a half relative to a composite of other currencies (known as the “trade weighted dollar”), but the reasons for this aren’t always well understood.

The value of the dollar relative to other currencies is determined by the balancing of truly colossal global forces. One of the things I learned early on in my career is that people in this business love to mention the dollar, perhaps to give the impression that they have a mastery of these complex global forces. But the drivers of the dollar’s value are very hard to quantify.

Currencies are commodities, and like commodities they are volatile. Even expert investors like Warren Buffet can bet wrong in commodities and lose big. And even if you knew in advance what a currency was going to do, it isn’t at all clear that you could craft an outperforming investment strategy based on it. Here’s why:

What drives the dollar?

The dollar can be driven by monetary, real, and precautionary forces. In a world where each country has its own central bank and rate of inflation, the value of each currency often reflects differences in the rate of inflation – or expected future inflation – among different countries. The price of one currency in terms of another adjusts so that you can exchange one currency into another and buy the same basket of goods. This is known as purchasing power parity and reflects primarily monetary forces at work.

But what if central banks pursue price stability, that is, accommodating the demand for money with the supply of money such that the price level in each country is more or less stable? This describes the developed world for much of the past 25 years. Under these conditions exchange rate movements don’t reflect monetary (inflation) factors but rather changes in the underlying real rates of return or terms-of-trade. This falls under the literature of real exchange rate economics, and it is extraordinarily difficult theory to grasp. Often differentials in the rates of return between countries are reflected in interest rate differentials, but interest rate differentials – like currencies – can also reflect monetary influences (different central bank policies) rather than differences in underlying real rates of return.

And finally, suppose a global collapse in confidence causes the world to sell assets and to hold cash, which would drive up the value of a “safe haven” currency. That’s exactly what happened to the dollar with the onset of the recent financial crisis. This reflects the precautionary influence on currencies.

So anticipating currencies demands a grasp of and ability to measure and predict (1) relative central bank or monetary policies between countries, (2) real rates of return or ‘terms of trade’ between countries, and (3) global confidence. That’s a pretty tall order, but right now I see all three working in the direction of strengthening the dollar.

How do currencies affect companies?

Many analysts assume that movements in the dollar affect companies that sell internationally. But companies also source (buy) internationally, and these two influences are often off-setting. And empirical studies show that exchange rates can affect cash flows in companies with no international exposure.

For example, a depreciating currency can make imports less attractive as consumers shift towards domestic import-competing goods. Those goods may be produced by companies with no international sales, and yet they are very much influenced by the value of the home currency. And the dollar’s influence also depends upon which currencies are relevant. A company with a lot of Asia exposure and no European exposure will be more sensitive to the Dollar/Yen exchange rate than the Dollar/Euro exchange rate.

In addition, many companies have good currency hedging programs, which can neutralize all of the above mentioned dollar sensitivities: Two identical companies with the same international sales profiles can be very differently impacted by currency movements, depending upon their hedging strategies. These hedging strategies are complicated and difficult, and some management teams are more skilled at it than others. Many companies would love to hedge but cannot afford the expertise to do so, which is why larger companies hedge more than smaller companies, even those with the same international sales/sourcing exposure.

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Jim Kee

Jim Kee, Ph.D. joined South Texas Money Management at the beginning of 2009 and serves as president and chief economist. His expertise lies in combining top-down, macroeconomic insights with bottom-up...