Dollar Strength

The strength of the US dollar is something that has been hotly debated of late. If you follow this measure each day, you see "ups" some days and "downs" on other days, but no dominant pattern (at least if you follow the financial press).

How should you follow the dollar? The dollar index ($USD) measures the strength of the US dollar against its major trading partners. It is not a bilateral exchange rate. Think of the dollar index as an equilibrium price -- in this case for the dollar. How is this price determined? Simply by supply and demand. So, you can use the supply and demand for dollars by the US and its major trading partners to model this variable. I will also refer you to my handout on Flexible Exchange Rates.

At the present time, it appears that relative US interest rates are the most important driving force for the Dollar Index. The Fed's indecision about whether it is done raising interest rates (at least in its post-meeting statements) has lead to recent market uncertainties and dollar "bounces." This is critical in light of recent slowing by the housing sector which has done much of the "heavy lifting" for our economy the past few years (an article about this).

In the last few days, the 10-year government bond ($TNX) has gained significant ground, breaking through resistance, finishing the day at 4.85%. This is NOT a good time to have money in bond mutual funds (see article).

How high will the 10-year go? To answer this, first examine a chart of $TNX and find support and resistance. Where is the next resistance? Are we close to that now? For extra credit (part 1), graph the 10-year bond using weekly data for three years in StockCharts.com. Change the moving averages to 10 and 40 periods (this makes them comparable to daily values of 50 and 200). Annotate this graph going back as close to the beginning of the three-year period as is necessary and draw relevant support and resistance lines. Print this out in a Word document. (do not hand draw the lines).

The other relevant question is how tied to interest rates the US Dollar is. According to economic theory, it is very tied, for reasons outlined in class and on the handout for Flexible Exchange Rates. For extra credit part 2, make a graph of the US Dollar Index ($USD) as a dotted line, remove the moving averages, and select Price as one of the indicators -- use $TNX -- and place this behind the dollar graph (this is done by changing the box from "below" to "behind price." Past this into the Word document and in one paragraph discuss how these two variables are related. Is it what theory leads us to believe? Bring this to our next class. It is due at the beginning of class on Tuesday.

In order to determine whether the 10-year bond might break beyond current resistance, you can use the model of interest rates we developed in class at the beginning of the semester. A forecast by you would allow you to make an "educated" guess as to whether we will break through the next resistance.