Dollar Risks Being Left Behind in the Search for Higher Returns

During times of economic uncertainty, buying and holding U.S. dollar-denominated assets has long been the standard “flight to safety” many investors have relied upon for shelter from the storm. In recent years however, this trend is waning and investors are turning more and more to the yen and Swiss franc to minimize losses as both currencies have proven more resilient to exchange rate fluctuations.

But it is not just as a “safe harbor” that the dollar is losing popularity. When market conditions are more favorable, risk appetite naturally increases and investors are willing to accept greater risk in the search for higher returns, and on this front, the dollar is also overshadowed. While most other major economies have either already implemented interest rate increases or appear close to doing so, the Federal Reserve continues to favor a continuation of the current record-low rate.

U.S. Losing the Interest Rate Race

Simply put, the dollar is losing the interest rate race and is seriously at risk of being left behind. Australia will continue to hold the top-spot on the list with a benchmark interest rate of 4.75 percent with New Zealand next at 2.5 percent. The European Central Bank hiked rates by a quarter-point last week to 1.25 percent and Governor Trichet strongly hinted that further increases are likely. The Bank of Canada, while opting not to implement an increase earlier this month, stated quite plainly that it expects to put forward a series of hikes later in the year if the economy continues to expand at the current rate.

Contrast these actions and comments with those emanating from the Federal Reserve. Growth is returning to the U.S. and employment is improving but it remains to be seen how the economy reacts with the wrap-up of the “QEII” stimulus spending program scheduled to conclude in June. We will soon learn if the economy has recovered sufficiently to stand on its own without the need for another multi-billion dollar round of spending.

With respect to interest rates, Fed Chair Ben Bernanke has essentially ruled-out an increase in interest rate hikes until late in the year at the earliest. This could be moved ahead if the economy exceeds expectations, but with the stimulus spending due to end in the early part of the summer, and with unemployment still around 8.7 percent or so, the Chairman’s prediction seems reasonable and a cap of 0.25 percent may be with us for some time yet.

USD to Fund Carry Trades?

So what does this mean for the dollar? From an interest rate standpoint alone, the dollar is without question at a disadvantage. In fact, we are seeing a greater use of the dollar to fund carry trades whereby investors sell the dollar in order to buy higher yielding currencies such as the Australian dollar or even the euro. If this continues, there will be even greater selling pressure on the dollar over the coming months.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.