The U.S. dollar fell in the wake of a new round of monetary easing by the Federal Reserve, but Canadian exporters and investors shouldn't count on that trend continuing. In the medium term, a strong rally in the greenback is far more probable than most people believe.
The law of supply and demand dictates that the more of something there is – in this case, U.S. dollars – the less valuable that something will be, everything else being equal. So an immediate 1.5-per-cent dip in the trade-weighted U.S. dollar index was an understandable reaction to news that the Federal Reserve will now be purchasing up to $45-billion (U.S.) a month in U.S. Treasury bonds. The purchases will add $45-billion a month to the amount of money in circulation, and dilute the value of existing greenbacks – in theory, anyway.
In practice, however, the future course of the U.S. dollar will depend on the success or failure of the Fed strategy. Success in the form of lower unemployment and a stronger economy would increase the attractiveness of U.S. assets and boost the flow of foreign investment into the U.S., particularly from Europe, where economic prospects remain dim. This inflow would provide support for the greenback, as euros would be sold to buy dollars.
In contrast, failure to reach agreement on the "fiscal cliff" – an issue over which the Fed has no control – could have the opposite effect on the dollar. Most economists believe that tumbling off the cliff would send the U.S. economy into recession despite the Fed's easy money policies. Recession would depress corporate profits and discourage foreign investment in U.S. equities, thereby dragging down the value of the greenback.
Canada's own currency will be buffeted by many of the same cross currents. Ottawa's financial position is far stronger than Washington's, which suggests our government bonds will continue to attract foreign buyers – a positive for the loonie. More evidence of economic recovery in Asia would provide further fuel for the Canadian currency, because it would probably mean increased foreign investment in domestic resource stocks. But if the U.S. economy strengthens significantly while China's economic outlook remains in doubt, the greenback is likely to climb against the Canadian dollar.
The Fed's gamble is that monetary easing will have enough of a positive economic effect to offset the dilutive effects of printing money. For now, the only sure bet is that investors should steer clear of those who claim they can predict with certainty which way the dollar will jump next.