Euro to Dollar : Economic Factors
If you are going to buy assets in dollars using euros, then you
need to
understand what factors affect the Euro to dollar
exchange rate. Naturally there are some effects over which we have
little control such as natural disasters and war. There are, however
many other indicators that we can use to give us some clues to the
future direction of the currency, if we just take the time to learn
about them. On anther site about the relationship of the
Euro vs dollar, I have
looked at interest rates and GDP. Now let's have a look at one of the
world's most important resource - oil.
Euro to Dollar : Oil
August
15th 1971, is probably not a date you will ever remember, but for
currency and in particular it's relationship to oil, this was a defining
moment for the future of OPEC dollars. On this day, President Richard
Nixon officially ended the US dollar's link to gold which had been the
policy of the US government since 1789. In effect this meant that OPEC
producers were no longer being paid in gold, but in a free floating and
'soft' currency, which was steadily weakening. In return for their oil,
they were paid in US dollars which were then reinvested primarily in
Treasury bonds.
The situation today, is very similar to that of thirty years ago, with a weakening dollar and no hard currency with which to pay for an increasingly scarce resource. Since oil importers pay in dollars, and oil exporters keep their reserves in the payment currency, this effectively provides the US economy with an interest free loan. Central banks that used to keep gold bars in their vaults have sold much of their precious metal. Now, they try to “manage” their currencies by raising or lowering interest rates, buying and selling them in the open market, and by a variety of other techniques. All major currencies are now considered 'soft'.
There are already a number of countries within OPEC that would prefer to trade in euros according to a recent statement, including Iran, Russia and even Saudia Arabia. President Putin considered this as a realistic option as long ago as 1999. Whilst this is a possible option, there are also others currently under consideration. These include pegging oil prices to a basket of currencies, rather than to any one single currency such as the Euro, which in the long term may suffer the same fate as the dollar. All these discussions are also set against a backdrop of political sensitivity and the war in Iraq and Afghanistan.
So, as overseas investors changing our Euro to dollar assets, how does all this help us reach a decision, or at least to reach a view of the longer term?
Over the last few years, there has been a strong correlation between oil prices and the dollar exchange rate. As oil has risen in price the US dollar exchange rate has fallen - in other words the two correlate negatively. If we plot the two we can see that the coefficient correlation between oil and the dollar is -0.70. So for most of the time that the dollar fell against the Euro, oil prices rose. What is not clear is exactly why this may be the case. One very simple explanation may be that as oil suppliers are paid in US dollars, and as the value falls, the suppliers simply increase prices in order to compensate for their loss of buying power in international markets - which would seem logical.
Now I am not advocating that this correlation should be the only basis for your decisions, it is simply one aspect of international currency exchange that makes buying or investing in assets overseas such as risky business. Some would argue that a correlation of -0.7 is meaningless, and to some extent I would agree. In my own trading I base decisions on a correlations of 0.8 and above ( either positive or negative ) , but is is another indicator of where and why an exchange rate may move in the future.
There are of course, many other factors which have affected the rise in oil prices. Increasing demand for a scarce resource such as oil have fuelled higher prices driven by the economic expansion in both China and India. Raw materials and commodities have followed suit. The invasion of Iraq has not helped the situation. In past episodes of rising oil price namely, 1974, 1980 and 2000, all the major central banks raised interest rates in unison. That always ended in a world recession, which was rather belatedly followed by deep cuts in central bank interest rates. After the oil spike of August-November 1990, when the fed-funds rate was above 8%, the Fed failed to reduce interest rates significantly until a year after the recession ended, thereby prolonging the agony still further. Now it seems that everyone is waiting for the FED to make it's decisions.
My own guess is that the US dollar is currently oversold and we will see some strengthening against other currencies in 2008 and onwards, perhaps back to a level of 1.35 against the Euro. However if oil prices continue to rise, then the pressure on central banks to cut rates will increase as economies worldwide start to slow. The nail in the coffin for the dollar would be an OPEC decision on adopting the Euro as it's base currency - whilst this seems unlikely at the moment, it is an ever present risk. One of the reasons this may never happen is that monetary union between countries is never successful when it has not been preceded by political union. Indeed these stresses are already starting to show between the member states. As the Euro increases in strength against the dollar, the more the Southern Mediterranean countries feel the pressure, such as Italy, Spain, Greece and even France.
OK - now in order to help you get the best Euro to dollar rates, let's have a look at the best and worst places to exchange your money!