Currency exchange rates result from a number of factors, including relative inflation rates, balance of trade and interest rates between countries. If inflation in the U.S. is low, relative to other countries, then manufactured goods in the U.S. will be cheaper than goods made in other countries. This relative difference in inflation rates and hence prices will lead to higher demand for the U.S. goods and an associated demand for dollars to purchase those goods, thereby strengthen the value of the dollar. This is the principle of demand and supply.
If interest rates are relatively higher in the U.S., foreign capital will flow into the U.S. to take advantage of the higher rates. To do this, investors will demand dollars, thereby increasing the value of the dollar. Trade is also a big determinant of exchange rates, due to the fact that a significant increase in the demand of goods and services from any given country e.g. the U.S. by say, the UK will require an increase in demand for dollars to purchase the goods, thereby strengthen the dollar relative to the pound.
The examples above are rather simplistic and the true picture is significantly more complicate e.g. one would have expected the dollar to be significantly weaker than it currently is due to the trade imbalances with Japan and China. However, the dollar has enjoyed relative strength due it its wide use worldwide e.g. oil is traded in dollars and many foreign central banks have significant investments in dollars, hence it is in everyone’s interest to ensure that the dollar remains strong. When the dollar weakens, the central banks of the countries that have dollar denominated investments stand to suffer significant losses. Another reason for the huge investments in dollars is the historically perceived safety of the dollar.
No one wants to be holding a depreciating asset. When the dollar declines relative to other currencies, goods and services made in the U.S. become cheaper and demand for goods manufacture in the U.S. increases. Likewise, investments in the U.S. such as in stocks, bonds, money market securities etc should decline especially if the currency continues to decline as the value of these assets decline when investors convert their dollar denominated investments to their home currencies. This argument assumes that the decline in currencies will continue and that investors will withdraw their investments in the short to medium term. For example, when the dollar declines relative to the Euro or the Canadian dollar, we tend to see more tourists visiting the U.S. since hotels and meals will be cheaper for the visitors. Hence there is a short-term benefit to a weak dollar, provided the decline is not a continuous declined that leads to a collapse in the currency.
For conglomerates (U.S. companies that operate worldwide), an appreciating Euro or Yen could be beneficial, in fact a lot of companies report significant gains due to currency translations, as they convert their earnings from affiliates oversees to dollars.
For individuals, the story is the same, if you invested $1000 in a currency that is appreciating against the dollar e.g. the Euro, and over a 12 month period the Euro appreciates 20% to the dollar, you will have gained $200 simply due to the appreciation of the Euro relative to the dollar. This gain also works for investors who hold Euro’s they will be able to purchase more goods in the U.S. Some investors routinely purchase commercial real estate and U.S. businesses whenever the dollar is weak relative to their currencies. As the world becomes more interconnected, investors will always take advantage of currency imbalances, borrowing where money is cheap and investing where they stand to benefit the most.
Investors who aim to gain from currency fluctuations should be mindful of the fact that trends can reverse and the safest bet is to be cognizant of the macroeconomic factors that lead to differences in exchange rates. As an investor, you always want to be holding a strong currency.