If you have not yet read Is Part 1: The Dollar May Remain Strong For Longer Than We Think available free to all readers, please click here to read it first.

In Part 1, we reviewed the key concepts that drive supply/demand (and thus the price/relative value) of the U.S. dollar. In Part 2, we’ll cover the dynamics that could push the value of the USD vis-à-vis other currencies much higher in the years ahead.

Interest Rates, Bonds and Carry Trades

To understand the price of any currency—measured in other currencies, gold, oil, etc.—we look at a currency as a special kind of commodity, one that greases transactional trade of goods and services and also serves as a store of value. Like any commodity, its price relative to other commodities is determined by supply and demand.

If demand is strong and supply is tight, the value will increase. This is the same for dollars, gold, oil, grain, bat guano, etc. The reverse is equally true: if demand slackens and supply balloons, the value will decline.

To understand the supply and demand for currencies, we need to understand the role of interest rates, sovereign bonds and carry trades.

The connection between interest rates and demand is self-explanatory: if interest rates paid at home are near-zero, and another nation’s bonds are paying a higher yield, it makes sense to sell (or borrow) one’s own currency and buy a bond denominated in another currency.

This is the foundation of currency carry trades.  PP.com’s own Davefairtex recently offered an excellent explanation of how carry trades work on the Gold & Silver Group forum:

 I believe that QE causes inflation in other countries by dropping rates to 0% which encourages carry trades, whereby traders borrow USD for extremely low rates here in the US, and then send it overseas to find a yield.  Cheap money in the US causes money to flow elsewhere, where rates are higher.

Carry Trade For Dummies:

Step 1) Borrow $1 billion US at LIBOR-1M rate; cost 0.16%.

Step 2) Trade $1 billion US for 1.075 billion AUD.

Step 3) Buy 1.075 billion 2-year AUD govt bonds; yield 2.52%

Step 4) Collect $23 million USD/year for doing no work at all.

Carry trades work in both directions for the dollar…