Yesterday, the Fed did what everyone expected by cutting interest rates. The 0.75 point interest rate cut was lower than the full 1 point rate cut that futures traders were expecting, but within the range most people expected. It is doubtful that this interest rate cut will revive the economy for more than a brief showing on the stock market, and most people expect further interest rate cuts in the future. President Bush also mentioned yesterday that he is willing to take further measures to revive the economy, but first he wants to see how his economic stimulus package pans out.
Rather than discussing future cuts and policies, let’s talk about the present: The U.S. dollar is now the second lowest yielding major currency. The lowest yielding currency is the Japanese yen, which has pretty much maintained that title since Japan’s financial meltdown in the '90s (see previous post: Could The U.S. Be Headed For A Recession Similar To Japan's In The '90s?), which was eerily similar to the one the U.S. is experiencing. The U.S. dollar yields 2.25 percent, while Japanese yen yields 0.5 percent. The dollar still has some room to fall before it gets that low, but it is well on its way.
Why is the yield of a currency important?
Investors want to see return on their money, so if they aren’t getting the returns they seek at home, they will start to look elsewhere. For a good example of this, we can look to Japan. The Japanese don’t want to keep their savings in yen because they earn almost nothing on it, and with inflation is higher than interest rates, they are actually losing money. Because of this, people take their savings elsewhere. As more people sell off their yen, the currency goes lower.
There are also the carry traders who borrow money at low interest rates and invest that money in higher yielding currencies hoping to profit from the yield difference. Again, these traders are selling the low-yielding currency (lowering its value further) and buying higher yielding currencies (raising their value). Carry trading has become popular of late, and its power to move currencies should not be overlooked.
For the reasons mentioned above and others, as currencies decrease their yield their value goes down, and as the yields get raised the currency value goes up. The fact that the U.S. keeps lowering the dollar yield is further reason to believe that the dollar will continue its slide.