Thursday, May 21, 2015

US Central Bank's statement reduces the value of the dollar

Almost everyone had assumed that the US Central Bank would start raising interest rates in June.  The just released notes from their meeting said that this is unlikely.

The dollar then fell agains the Euro
Early afternoon in Europe, the euro was around 0.3% higher on the day at $1.1126, reversing some of the losses it had suffered during the previous two sessions after European Central Bank officials reaffirmed the bank’s resolve to meet its stimulus goals.
Why does this happen?

There are two mechanisms at work:

  1. lower US interest rates reduce investment demand for the dollar:  fewer investors want to invest in dollar-denominated investments, which represents a decline in demand for dollars in the market for foreign exchange.  
  2. lower US interest rates increase loan demand for the dollar:  more foreign borrowers want to borrow in dollars to invest abroad.  To do this, they go to US banks, borrow in dollars, and then sell dollars to buy the local currency where they want to invest.  This represents an increase in the supply of dollars.  This is called the "carry trade."

Both the increase in supply of dollars and the reduced demand for dollars result in a depreciation of dollars in the market for foreign exchange.

"Wait a minute" asks a student.  "Can this really happen so quickly?"

No, these kinds of moves take time.  However, if speculators know what will happen, then they can "front run" these changes (profit from them) by selling dollars and buying foreign currencies, today, which will make these expected future changes occur immediately.

1 comment:

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