With the U.S. dollar at its strongest in a generation, it’s devaluing currencies around the world and upending everything from the cost of a vacation abroad to multinational companies’ profitability. Global economic activity is lubricated by the dollar. Before the pandemic, it accounted for $6 trillion in foreign exchange transactions every day, from tourists using credit cards to businesses investing globally, according to BIS.
Dollars often rise in times of turmoil due to their status as the world’s most important currency, in part due to their perceived safety and stability. Recent months have seen the dollar rise as inflation has soared, interest rates have risen and worries about growth have increased. Goldman Sachs co-head of market research Kamakshya Trivedi remarked, “That’s a pretty tough mix.” To evaluate the strength of the dollar, it is indexed against a basket of currencies of major trading partners such as Japan and the eurozone. That means the dollar has reached a 20-year high, after gaining more than 10 percent this year, a huge move for an index that typically moves by tiny fractions.
There are several factors underlying the dollar’s sudden strength, including the turmoil in the global economy. Globally, central banks are raising interest rates to tame inflation, but the Federal Reserve is doing so more quickly and aggressively than others. Consequently, US rates are now higher than those in most other large economies, luring investors attracted to high returns on even conservative investments like Treasury bonds. The dollar’s value has increased as money has poured in. According to Bank of America analysts, the Fed’s comparatively aggressive policy alone could explain more than half the dollar’s rise this year. During times of worsening economic conditions and stock market turmoil, analysts pointed to its status as a safe haven.
Additionally, they said the dollar was rising because high energy prices were impacting importers, including most of Europe, more than the United States, which is less dependent on foreign oil and gas.
Despite tightening policy from the Federal Reserve (Fed); the Federal funds rate was raised by 0.75% at the July meeting, we do not find US interest rates to explain dollar strength. Due to the global nature of the current tightening cycle, interest rate spreads have not moved significantly in favor of the US dollar. There has been a lack of alignment between short-term market movements and rate spreads in recent months. Due to the large increase in currency volatility, the carry available on the US dollar against low yielding funding currencies does not appear particularly high. There is currently a carry-to-risk ratio of around 0.30, as per J.P Morgan Chase, which historically indicates when carry becomes a major theme in currency market movements. However, this level is well below the 0.40 to 0.70 levels seen between 2006 and 2008, and between 2018 and 2020, when carry strategies were more intensely emphasized.
In J.P. Morgan’s view, the US dollar’s strength is mainly due to its rising safe-haven premium in an environment of high inflation, a major geopolitical shock to energy markets, and increasing recessionary risks. The historical experience shows that duration is a less effective portfolio hedge when inflation is high. In both high inflation and low inflation regimes, the US dollar has historically been negatively correlated with equity markets. Increasing inflation has pushed multi-asset investors into US dollar allocations and raised the dollar’s safe-haven premium.
Secondly, the Russian invasion of Ukraine and subsequent disruptions to trade have had a large impact on commodity prices, including energy. North America is largely self-sufficient in energy commodities, but Europe and Asia are reliant on imported energy commodities. This has resulted in a major shift in trade in favor of the US dollar. The impact of price increases has become apparent in the trade balances of Europe and Japan over the past few months, with J.P Morgan forecasts predicting further declines. Changing trade flows directly affect supply and demand for currencies, with the US dollar benefiting as the primary currency for commodities.
Lastly, the global growth outlook has deteriorated as financial conditions tighten and energy prices rise. We observe an exceptionally high safe haven premium in the dollar due to recession fears that weigh heavily on sentiment towards a wide range of risk assets. The US dollar’s elevated safety premium is expected to decrease over the next few years, however. By late 2024, current infrastructure investments should narrow the gap between US and European energy costs, even without any resumption of Russian energy exports. The US dollar will also regain its role as a global safe haven asset if bonds regain their negative correlation with equities.
Extreme valuations are likely to offer opportunities for currency investors with a long-term perspective. The economic headwinds that support the US dollar remain a challenge for those seeking a tactical approach. The present environment favors relative value strategies due to different levels of exposure to energy price shocks, as well as strategies that seek to minimize overall beta to risk assets, while closely monitoring signs of safe haven demand peaking.
The strength of the dollar can be a mixed blessing for people and companies, but such a rapid increase in the value of the world’s most widely used currency can also be destabilizing. The strong dollar has also boosted sales for companies outside the United States. According to Burberry, the British luxury goods maker, currency movements will add more than $200 million to its revenue this year, helping offset a decline in sales in China.
When converting foreign sales back into dollars, American companies with large international operations suffer. Nike and Microsoft, for instance, have experienced recent declines in profits. The dollar’s strength is likely to hurt Apple and other tech giants, which dominate many stock indices, as they reveal their latest financial results shortly. Apple generates more than 60 percent of its sales outside the United States.
The rise in the dollar will reduce S&P 500 earnings growth by 5 percent this year, or roughly $100 billion, according to Ben Laidler, global markets strategist at eToro. According to FactSet, earnings among those companies are expected to grow around 10 percent this year. According to S&P Dow Jones Indices indexes, companies with most of their revenue generated in the United States have fared better than their international counterparts. A strong dollar is a big problem for companies and governments abroad that borrow in dollars. Poorer countries, especially those with less developed local markets, are particularly attracted to dollar-denominated debt. The most affected countries are likely to be those whose dollar debt makes up a large portion of their gross domestic product. Countries with rapidly depreciating currencies, such as Argentina and Turkey, have found it particularly challenging to pay interest to creditors in dollars, particularly as interest rates on any new debt will also rise. It has become almost impossible in some cases, such as Sri Lanka.
Despite its strong performance this year, the dollar has not been able to beat every currency. Oil-producing Angola, Uruguay, and Brazil, which sell a lot of energy and agricultural commodities, have benefited from the rise in energy and food prices caused by Russia’s invasion of Ukraine. This year, the Russian ruble has been one of the best-performing currencies against the dollar. The official exchange rate has been supported by high oil and gas prices, as well as Russian capital controls.
As Europe faces an energy crisis, Japan resists raising interest rates, China’s Covid-19 lockdown policies snag its supply chains, and other countries teeter under the burden of high inflation, demand for the dollar remains healthy. However, it remains unclear for how long. Bank of America analysts observed that “investor conversations have focused on what could lead to a peak” in the dollar’s value, rather than what will boost it another 10 percent.
According to Maurice Obstfeld, a senior fellow at the Peterson Institute for International Economics, a strong dollar can negatively affect the global economy in general and emerging market economies in particular. “The stronger the dollar, the slower the growth and the lower the volume of international trade,” he said. In particular, that hurts open, emerging economies, as it leads to lower commodity prices.
Former chief economist at the International Monetary Fund, Obstfeld said that a strong dollar is particularly problematic for poor countries, where declining demand and lower Gross Domestic Product, as well as higher debt service costs, are correlated with it. He noted that emerging markets have become more able to issue government debt in their local currencies, but they still borrow in foreign currencies, and their businesses are heavily indebted in dollars. It tends to make all those debts more expensive when the dollar rises, impacting financial conditions in emerging markets.
In response to a question about how long the current cycle is likely to last, Obstfeld said, “With all of the pressure on emerging economies, their currencies are likely to depreciate more against the dollar in the short run. That alone will tend to strengthen it. Therefore, I believe we will be here for a little while.” However, he added that if the U.S. moves into recession and the Fed starts loosening, provided other countries aren’t even worse off than the U.S., you could see the dollar start to come down over the next six months.
As a result of the war on the eurozone’s border, the uncertain energy supply from Russia, and the growing recession risk, the euro finally fell below parity with the U.S. dollar in July. The sight hadn’t been seen since December 2002, when the currency first appeared.
It’s been a bad year for the euro, as the dollar has been almost unbeatable in strength. Dollar strength has led to a sharp decline in the euro, which has been a safe haven for generations. Challenges for the currency are being further accentuated as a result of challenging economic conditions in the Eurozone.
In April, Jordan Rochester, a strategist at Nomura, predicted that the euro would reach parity with the dollar. Other banks made similar predictions, including JPMorgan Chase and HSBC. There was then a brief respite from the euro’s decline.
Christine Lagarde, president of the European Central Bank, laid out a clear plan to raise interest rates for the first time in more than a decade in July, signaling that the eight-year era of negative interest rates would end by early fall. Policymakers have intensified their commitment since then, saying that when rates rise again in September, the jump will be greater than in July. In the end, it wasn’t enough to turn around the currency’s trajectory.
Early in July, HSBC analysts wrote to clients: “It is hard to find much positive to say about the euro. It’s a challenging time for the economy.”
A weaker currency poses an extra headache for the European Central Bank, since it will increase the cost of imports in the region, increasing inflationary pressures. Since the forces pushing up the dollar have been so strong, it will be hard for central bankers to address the currency’s decline with words.
For the foreseeable future, the dollar will remain the dominant currency in the global economy. While long-held concerns about U.S. trade deficits and budget deficits persist, dollars remain in high demand for global transactions and trade.
In addition to global financial transactions, most commodities, such as oil and soybeans, are traded in U.S. dollars. Importers of those goods must hold dollars to make trade purchases. U.S. Treasuries are usually held by exporters for future transactions. Subsequently, global trade and investment are supported by the size and liquidity of the U.S Treasury market.
The dollar is the only alternative that can fulfill these needs. Although the euro plays a large role in financial transactions, its fragmented bond market and long period of negative interest rates have limited its use. The Ukrainian conflict has further inflicted a massive toll on the power of the Euro. In Asian competitors, Japan’s zero-interest-rate policy and yield curve control have made the yen highly unattractive.
A New Player in the Game: China’s RMB
However, with this being said, there is another question that remains unanswered. Is China’s currency likely to become more important internationally after the dramatic events of 2022?
With its first issuance less than 75 years ago, China’s renminbi (RMB) is a relatively young currency. On the other hand, the U.S. dollar has been issued since 1785 and centralized by the Federal Reserve since 1913. But since reform began, the RMB has undergone multiple changes in terms of management, exchange value, and global importance.
In 2003, Hong Kong began promoting an international role for the RMB on a limited, off-Mainland basis and gradually expanded to allow the sale of RMB bonds in 2007. The hard peg to the US dollar was lifted in mid-2005, and the current flexible exchange rate management mechanism was established. In 2010, a range of initiatives for bond sales and trade-related exchanges were authorized, leading to the formal introduction of the special overseas version of the domestic currency in 2011 and the first Hong Kong public offering. The RMB’s international role has grown substantially since its first steps were taken less than 20 years ago.
There has been a dramatic growth in the usage of the RMB as a medium of exchange as well. The Society for Worldwide Interbank Financial Telecommunication (SWIFT) reported that the RMB accounted for 1.67 percent of all settlements in January 2020, making it the sixth largest settlement currency. Almost two years later, in January 2022, the RMB settlement had doubled, taking the fourth place behind the US dollar, the euro, and sterling, accounting for 3.2% of all settlements. The growth rate is dramatic, but the base is small.