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November 20, 2008

Global Financial Meltdown, US Economy in Recession & Greenback RISING ?? You must be kidding!

Last couple of years, have been scripted with lot of surprises and events that we still fail to understand. We tend to doubt our fundamental understanding of the whole concept of Finance and Economics. Then when we go on to analyse the sequence of events, we put our foot down and say " yes, the butterfly effect is indeed true". A butterfly may flap its wings in Indonesia, which might trigger a Hurricane in the Atlantic. Well, that does not answer all the questions. Does it??

Skipping the first part where we discuss how did all happen, will be a bit too much on this blog, so I shall continue with the assumption that yes, its true we are in the middle of the crisis and US is to be blamed for it. (Many Americans might  suggest or sponsor the Federal Reserve to take a few courses in the leading business schools to learn the basics and fundamentals of Financial Economics!) But how come, amidst all this US recession, the green back starts rising like never before against all currencies in the World ( you might exclude Chinese Yuan from this for most obvious reasons ! ).

Well the first fundamental theory of Economics suggest that when the Central Bank lowers the interest rate, it makes reduces the attractiveness of investing the economy, leading to low FDI and exchange rate depreciation ( which is why we see Japanese Yen depreciated). While the best  of memory is the interest rate in US currently is around 1.5%!! Just to spare some embarrassment for the Federal Reserve, it did this not for kicks, but it wanted to increase business confidence, lending and borrowing and investment in the economy. However, as we all know the the second child of low interest rates is inflation, which is what we are witnessing, but surprisingly these tempting low interest rates did not help business confidence; the banks were still apprehensive about lending and investing, PLAN FAILED - consequence - STAG flation. Well, we are here to discussion what in the world then appreciated the US currency, as all of these suggest that nothing could have helped US greenback, in the coming years.

Well, all was not going wrong for US! Although the interest rates are at an all time low, it seems that the global demand ( from other countries) for US Government Debt has been increasing significantly. The recent events of the bankruptcy of banks have taken a huge hit on  the confidence of the investors worldwide; so the best thing they could think of was to take out all their capital from risky stocks and other risky financial products, and invest it in something safe and with a long term perspective - long term US Treasury Bonds ( which gives around 3.5% p.a on a 10 Year Treasury Bond, compared to negative returns for others). This investment is considered risk free - only when we assume that the after the banks , the Government itself does not go bust !!!We can definitely the US govt for this ( its own welfare , if not the people).

Now the question is how does this relate to appreciating US dollar. Well, surprisingly the correlation between EUR/USD and 30 Year US Treasury Bond is a staggering -0.82; which means that every 1 %  increase in US Treasury Demand, implies a fall of 0.82% of EUR/USD. So people are cashing dollars and buying US debt, which appreciates the dollar against Euro.

However, there are factors as well. Consider the US trade deficit. it fell from $60 billion in July 2008 to $56 billion in September. Also look at the oil prices it was over a $120 a barrel and now it hit less than $50 a barrel as on November 20, 2008. US being the largest consumer and importer of oil, will definitely reduce its oil bills by this development, leader a improved trade deficit ( around $40 billion). This means less USD is going out of the world economy ( outside US) and investors want to invest in the attractive long term US treasury Bonds. So the demand for dollars is definitely increasing, and given the short supply due to lower import bills, calls on a reasonable explanation as to why the greenback is rising.

An important point to note here is know the how exactly the USD travles arounf the world. The thumb rule is that whatever USD goes out of the US economy ( it only goes through the economy, no other bank or any WORLD bank issues USD), comes back in the economy, in some form or the other.  For instance, China holds the largest reserves of USD in the world ( around $2 trillion), and like many other countries it keeps USD as the reserve currency. Governments lend to each other, trade, and invest in US economy with USD, but it can also hoard a lot of its reserves in USD, creating a shortfall in the general supply of greenback currency. However, the most obvious investment of all the governments who keep USD as their reserve currency, is US government debt ( US Treasury Bonds); and as we have already stated, by doing this keeps USD within the economy and its given highly negative correlation with Euro and other major currencies, is evidence enough for the appreciatiing US Dollar.

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