According to The Wall Street Journal, “The euro rose to $1.2985 late Thursday from $1.2894 late Wednesday. The euro rose as high as $1.3001 Thursday, its highest point against the dollar since May 9.” Why in the world is this happening? Isn’t it bad when the dollar weakens? In this article, I want to address the Foreign Exchange Rate(FOREX) process for “dummies” and why the Euro has been appreciating.
For the purpose of understanding FOREX rates, I will only discuss two basic reasons why the dollar has depreciated recently, European Central Bank activity and the Federal Reserve’s recently announced Quantitative Easing three(QE3.)
According to The Wall Street Journal, “The euro has rallied 6% against the dollar since early August on optimism that the European Central Bank can relieve financial stresses in struggling Euro-Zone countries.” Unless you live under a rock, you should be aware that the Euro-Zone has recently been experiencing extreme economic difficulty. Why would Central Bank activity boost the value of the Euro? Simply, foreign investors seek out stable countries with strong economic performance to invest their capital. Investors are beginning to have more confidence in the Euro-Zone, thus investing money into various financial instruments. For the purposes of your understanding, think “Investor confidence in a country= increased demand for countries currency= appreciation of said country’s currency.” This simple concept is one explanation for the US dollars recent depreciation in the FOREX market.
Today, the Federal Reserve announced another round of Quantitative Easing (QE3.) What is this? To fully understand, we need to discuss a few concepts first. The interest rate heavily relies on what is known as the money supply. The money supply is what it sounds like, the amount of money circulating through banks and financial institutions. The more money there is, the lower the interest rate. Higher interest rates signify a smaller money supply. In theory, when interest rates are low, people will borrow more money. This borrowing leads to positive economic activity, boosting GDP and reducing unemployment. Follow me so far? Quantitative easing is simply when the Federal Reserve purchases a massive amount of bonds to increase the money supply. This purchase leads to lower interest rates, which in theory is good for the economy. That’s why on the news you may constantly hear about how the Federal Reserve wants to extend low interest rates. They think it will be beneficial for the economy. However, this process actually weakens the dollar. Foreign investors have no desire to invest in low yield financial instruments. Low yields are great for borrowers, but terrible for investors. Investors will seek out other countries to invest their funds in. Thus, other currencies appreciate relative to the dollar.
There is far more to discuss on this topic, but I hope this little discussion has shed some light on current financial events. It’s important to understand the world around you! Please let me know if you have any questions.