Value of the U.S. Dollar Compared to Other Currencies

The U.S. dollar is most easily measured by its exchange rate, which compares its value to other currencies. Exchange rates change every day because currencies are traded on an open market.

Exchange Rate Trends:
From March to September 2009, the dollar's value fell 14.9% against the euro. This is a result of the nearly $12 trillion U.S. debt, which reduces confidence in the dollar's value. Prior to that, businesses hoarded dollars since credit wasn't available, creating an 11-month dollar strengthening cycle. The dollar's value increased 22% from April 2008 to March 2009. For six years prior to that, the dollar weakened. Between 2002 - 2008, the dollar lost 40% of its value. In 2002, a euro was only worth 87 cents.(Source: Federal Reserve Foreign Exchange Rates; Federal Reserve Bank of New York, Historical Exchange Rates)

The dollar is declining for the following reasons:
The U.S. debt is rising to over $12 trillion. Foreign investors are concerned that the U.S. will let the dollar decline so the relative value of its debt is less.
The large debt could force the U.S. to raise taxes to pay it off, which would slow economic growth. As more countries join or trade with the EU, demand for the euro will increase. Foreign investors may want to diversify their portfolios with more non-dollar denominated assets. As the dollar resumes its decline, investors will be less likely to hold assets in dollars as they wait for the decline to stop.

Value of the Dollar as Measured by Treasury Bonds:
The value of the dollar is also measured by the demand for U.S. Treasury Bills, Notes and Bonds. Treasury bills, notes and bonds are sold at auction by the U.S. Treasury Department and can be bought for more or less than the face value, depending on demand. They can also be resold on the open market, and the price can fluctuate further. The greater the demand, the lower the yield that the Government has to pay investors. Conversely, when demand falls, then the Government must pay a higher yield to attract investors back. Since January, the value of the dollar as measured by Treasuries has weakened. On May 18 2009, the 10-year Treasury Note yield was 3.21%. This is a 49% increase since January 15, 2009 when the yield was 2.15%. An increase in the Treasury yield is a decrease in dollar value. In the seven years prior to that, the Treasury yield had been declining. The January yield of 2.15% was 57% lower than the March 2002 yield of 5.02%. This meant that the demand for dollar-denominated Treasury notes was strong. (Source: U.S. Treasury, Daily Treasury Yield Curve Rates). Since January, the value of the dollar is weakening as measured by both exchange rates and by Treasuries. The world is in a recession, and investors want a safe haven. The higher the U.S. debt level, the less safe the dollar seems. Basically, the Treasury is auctioning more notes than there is demand, forcing yields to rise.

Value of the Dollar as Measured by Foreign Currency Reserves:
The dollar is held by foreign governments who have an excess of cash, held in foreign currency reserves. This excess happens when countries, such as Japan and China, export more than they import. If these countries were concerned about the declining dollar, there would be a decline in the percentage of reserves held in dollars. In fact, as of Q4 2008 (most recent report), there was at least $2.7 trillion of foreign government reserves held in dollars. This represents 64% of total measurable reserves, down slightly from Q3 2008, when dollars comprised 67% of measurable reserves. Since the percentage of dollars is slowly declining, this means that foreign governments are slowly moving their currency reserves out of dollars. In fact, Euros held in reserves increased from 393 billion to 1.1 trillion during this same time period. (Source: IMF, COFER Table)

How the Value of the Dollar Affects the U.S. Economy:
When the dollar declines, it makes U.S. produced goods cheaper and more competitive when compared to foreign produced goods. This could help increase U.S. exports, boosting economic growth. However, it also leads to higher oil prices in the summer, since oil is priced in dollars. Whenever the dollar declines, oil producing countries may raise the price of oil to maintain profit margins in their local currency. For example, the dollar is worth 3.75 Saudi riyals. Let's say a barrel of oil is worth $100, which makes it worth 375 Saudi riyals. If the dollar declines 20% against the euro, two things happen. First, the value of a barrel of oil has declined 20% to the Saudis. Second, the value of the riyal, which is fixed to the dollar, has also declined 20% against the euro. To purchase French pastries, the Saudis must now pay more than they did before the dollar declined. To avoid this, the Saudis must raise the price of oil, which they do by threatening to limit supply.

The $11 trillion U.S. debt is weighing in the back of the minds of foreign investors. That is why they may continue to gradually move out of dollar denominated investments - slowly, so they don't diminish the value of their existing holdings. The best protection for an individual investor is a well-diversified portfolio that includes foreign mutual funds. (Last updated May 19, 2009)