In light of much of what has been going on - from a macro economic perspective - I felt it might be appropriate to review some of the fundamental factors that affect [or should affect] a currency's worth. As we can see below,

the U.S. dollar [as measured by the U.S. Dollar Index] has been strengthening from roughly the Spring of 2005. Let's examine some of the fundamentals to ascertain whether or not this rise in the dollar's value has been warranted.

Forces Behind Exchange Rates

According to Jason Van Bergen at Investopedia.com,

Fiscal policy is the means by which a government adjusts its levels of spending in order to monitor and influence a nation's economy. It is the sister strategy to monetary policy (see Formulating Monetary Policy), with which a central bank influences a nation's money supply. These two policies are used in various combinations in an effort to direct a country's economic goals.

Well, we certainly do not need to go on ad nausea in this space about U.S. fiscal policy. Suffice to say that policies in place have led to arguably unsustainable deficits of the current [trade imbalance] and fiscal [government spending] accounts.

The responsibility of administering the monetary policy in the U.S. falls on the shoulders of the Federal Reserve. The tools at the Fed's disposal to carry out this task are most commonly thought to be interest rates. While interest rates are indeed a powerful 'lever' in determining demand for credit - and thus the economy's fortunes - it is not the only tool the Fed has at its disposal.

The Fed sets Reserve Requirements for the banking system. By altering the level of reserves that deposit taking institutions must hold in their vaults or on deposit with the Regional Fed Banks - the Fed can directly affect the aggregate money supply in circulation.

The Fed has another powerful tool in its bag - called Open Market Operations - that enable the Fed to rapidly inject or withdraw vast amounts of money into the banking system via repos [short term borrowing - or purchase and resale - of securities from the market place] or matched sales [short term selling and subsequent repurchase] of securities through member banks and investment houses. This powerful tool [open market operations], in effect, allows the Fed to be seen to be acting with constraint [reigning in inflation] in the economy whilst simultaneously opening the monetary or liquidity spigots [doing exactly the opposite] in terms of injecting 'short term' cash in the banking system. Needless to say, over the past 12 Fed hikes in interest rates [dating back to June 04] - which have seen the Fed raise rates from an historic low 1% to the current 4% - virtually all open market operations undertaken by the Fed have been through the repo [monetary aggregate add] mechanism. Interesting, in my opinion, from a group that preaches how vigilant they are on preventing inflation.

So, there you have it folks, on the fiscal front - an accident looking for a place to happen and on the monetary front - a central bank [the Fed] that seems [by empirical observation] to want to have it both ways. Many would argue that this is decisively fundamentally negative, yet the dollar appreciates?

But Why?

In a fiat monetary system where no money is backed by the discipline of the gold [or equivalent] standard - governments and central banks are ultimately free to create as much currency as they desire - at virtually no cost - unless you want to consider misallocation of resources and asset bubbles "costly." We certainly do have our fair of these now, don't we?

In a globalized world - one that depends on international trade to the extent ours does - countries tend to act in mercantilist self interest, not allowing their currencies to appreciate against their counterparts to ensure the vitality of the export sectors [and accompanying jobs] of their economies. As such, under a fiat money regime - when an export led economy sees their currency start to rise in value [lessening foreign demand] - they simply "print" their domestic currency to buy "or prop" the devaluing currency to maintain the status quo. A negative side effect of all this is, left unchecked, all this money printing tends to be 'highly inflationary.'

Has anyone [with the exception of the Fed, of course] noticed any inflation?

And If All Else Fails

If your currency fundamentally wants to "fall" in value [meaning foreigners want to liquidate] - and you want to protect or project an image of the opposite - there are other ways you might consider 'picking up the slack,' so to speak. Consider this if you will:

Chavez Moves Venezuelan Money Out of U.S.
Associated Press

Venezuela has moved its central bank foreign reserves out of U.S. banks, liquidated its investments in U.S. Treasury securities and placed the funds in Europe, Venezuelan President Hugo Chavez said Friday.

"We've had to move the international reserves from U.S. banks because of the threats," from the U.S., Chavez said during televised remarks from a South American summit in Brazil.

"The reserves we had (invested) in U.S. Treasury bonds, we've sold them and we moved them to Europe and other countries," he said.

Chavez, a sharp critic of what he calls "imperialist" U.S.-style capitalism, has often criticized foreign banks for the power they wield in international financial markets at the expense of poorer countries.

Chavez again proposed the creation of a South American central bank that would hold the foreign exchange reserves of all the central banks in the region.

"I'm ready right now with the Venezuelan central bank ... to move $5 billion (euro4.15 billion) (of Venezuelan reserves), to a South American bank," Chavez said.

Central bank officials could not be immediately reached for more details.

Chavez has also argued against central bank autonomy, saying excess foreign reserves should be spent on economic development projects.

Under his presidency, Venezuela's mostly pro-Chavez Congress changed central bank laws earlier this year so the government could tap reserves for spending, despite criticism that it would lead to devaluation of the local currency and higher inflation.

Every year the central bank must now compute an "optimum" amount of reserves and hand over the rest to a newly created national development fund.

Money held in the fund will be used for overseas purchases and to pay off outstanding debt.

Foreign exchange reserves held by the central bank stood at $30.434 billion (euro25.27 billion) as of Sept. 28, according to central bank data.

I recently wrote about this happening [outlined above] - here at Financial Sense. I've also written quite extensively about the Pirates of the Caribbean/irregularities in TIC data. Well, consider if you will - that Venezuela is an OPEC country and they "dumped" their U.S. government bonds in September/05 [to the tune of 15 - 20 billion as reported above]. Now look at the U.S. Fed/Treasury reporting on TIC data just released this past week for the month of Sept./05:

Notice that the total of U.S. debt obligations for OPEC actually increased in the month of September? On Thursday, November 17, 05 - CNBC's Steve Liesman did a segment on the TIC data and explained that the Caribbean is a proxy for hedge fund buying of U.S. debt, and the U.K. is actually where the bulk of OPEC holdings are captured. Well, the U.K. holdings increased in September, too!

I wonder who really bought Venezuela's 20 or so billion they "pitched." Whoever it was, perhaps their last name ends with Snow or Greenspan.

In conclusion, there are more ways than one might suspect to create the myth [or reality] of a strong currency - at least temporarily!