With U.S. economic growth now well grounded, the U.S. dollar (US$) is expected to rise this year against most currencies, including the euro and the Canadian dollar (C$). The US$ also will rise vs the yen, primarily because of Japan’s government policy rather than the U.S.’s superior growth.

For Canadian investors, the declining C$ vs the US$ is positive because it will increase returns on U.S. investments when translated into C$. However, your clients would be well advised to hedge their yen exposure because that currency is likely to drop by more than the loonie.

What the rise in the value of the US$ means for those with European exposure is unclear. Most fund portfolio managers expect the euro to drop against the US$ but not necessarily by more than the C$.

The euro was strong in 2013, ending 2013 at US$1.37 (vs US$1.32 12 months earlier). This strength was surprising, given the 100-basis-point rise in U.S. long-term interest rates after the U.S. Federal Reserve Board said last May that it was considering tapering quantitative easing (QE) – its bond purchases from private financial institutions. In theory, that announcement should have resulted in the selling of European investments, with the proceeds being invested in U.S. securities. But that didn’t happen.

However, economists don’t foresee the euro staying high this year. U.S. long-term rates are expected to continue to move higher, albeit gradually, and the European Central Bank will be printing more euros as it fights the threat of deflation in its region. Stéphane Marion, chief economist and strategist with Montreal-based National Bank of Canada, for one, thinks the euro will drop by US10¢ to around US$1.27.

A lower euro is needed badly. At US$1.37, it’s tough for European exporters to be competitive – and many European countries rely on foreign sales to help drive their economic growth.

Unlike in Europe, emerging markets did experience the expected outflow of money when U.S. long-term rates started moving up last May. The odds are that many of these markets’ currencies will soften some more with the onset of QE tapering.

A drop in emerging-market currencies vs the US$ would be bad news for many emerging countries. For those with large trade deficits, a dropping currency pushes up the cost of imports and, thus, their deficits, forcing these countries to borrow more abroad to finance the shortfall. This problem is compounded for countries that also are major resources exporters, which are seeing downward pressure on their currencies because of commodities prices that aren’t expected to rise this year and may even drop a little.

India, Brazil and Indonesia have large trade deficits; Brazil and Indonesia are major resources exporters. India’s rupee fell by 11.4% in 2013 against the US$, the Brazilian real was down by 13.3% and the Indonesian rupiah dropped by 21.2%.

The mechanics of exchange rates are superficially simple – a matter of demand and supply. But demand is complicated – it isn’t just a matter of the currency needed to pay for imports; there also are investment flows and speculation. For emerging markets, the impact of the latter two can be significant because emerging-market investments are not core investments for most investors.

The supply side also is important – particularly now, when central banks are printing huge amounts of money. This includes the U.S., in which the money printing will continue as long as the Fed is buying bonds from financial institutions. But there’s also lots of money being printed in Europe and Japan – and all these additions to the currency stocks feed into the supply and demand equation.

This sets up competitive devaluations in which each country, including the U.S., tries to drive down the value of its currency by pushing supply above demand.

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