The US dollar has never been higher against the Federal Reserve’s broad trade-weighted currency basket than it is right now, which has the media and many investors worried.
The simplest explanation for the dollar’s appreciation is already understood by many: US interest rates are higher than in most other developed markets. With all else equal, global capital typically flows to higher-yielding assets. This year has been no different, with money flowing to America, given that US short-term interest rates are higher than most developed countries and a sustained belief that the Fed will continue tightening aggressively. Canada, notably, is an exception. Short-term rates in Canada have often exceeded US rates this year, thanks partly to the Bank of Canada’s 100 basis point rate hike on July 13, 2022.
Besides fundamental rate differences, the dollar could also be rallying for sentiment-driven reasons. The US dollar has long been a popular safe haven, and with a wide range of fears this year—Russia-Ukraine war, spiking oil and gas prices, supply-chain disruptions, inflation, rising interest rates, and a possible recession, it has boosted dollar demand.
In addition, there are fears in the developed world that revolve around the dollar making US exports too costly—in turn, harming American multinationals’ foreign profits when they get converted back into US dollars. Both of these fears ignore the reality that many firms import a lot to complete their end products and to operate in diverse geographic locations. A strong dollar lowers imported components, resources, and labour costs. Many also ignore that currency conversions are often accounting entries that don’t reflect the core business, and a predominance of money earned abroad in foreign currencies gets redeployed right back into those same currencies. This reinvestment into foreign currency is why many multinational firms now include constant currency earnings and revenues alongside GAAP and IFRS reports (and many companies even hedge for currency effects to offset big swings).
Further concerns in the media concentrate on dollar strength causing the UK, eurozone, and Japan to import inflation, as a strong dollar makes US exports of goods and services—and all dollar-denominated imports—more costly. Yes, a strong dollar can exacerbate oil prices—and energy has been a significant contributor to the rising costs in Europe, the UK, and (to a lesser extent) Japan. But remember, inflation is a global phenomenon, especially in the developed world, where capital flows freely across borders. Most of the world is suffering from the same price pressures—namely, supply chain issues tied to reopening and the Ukraine war. Besides, American exports only constitute about 10% of UK imports, eurozone imports, and Japanese imports, which is likely too small to matter significantly. It is also good to remember that past periods of currency weakness in Britain, Europe, and Japan didn’t bring runaway inflation.
You are also finding strong-dollar fears about Emerging Markets (EM), with many trying to connect risks related to the 1997-1998 Asian Currency Crisis. Yes, a few smaller EM countries like Turkey and Egypt face funding pressures, but they are well known. Whereas the largest EM economies in Asia have free-floating currencies with relatively little dollar-denominated debt and ample reserves to service them—on average, less than 5% of Asian EM government debt is in dollars.
Another difference today from the 1990s: Many EM central banks implemented quantitative easing (QE) during pandemic lockdowns. These banks included India, the Philippines, Chile, Poland, and Indonesia. Assets collected under QE could allow them additional monetary policy flexibility. Take the Bank of Indonesia (BI), which started selling some of its QE bonds. It should enable BI to raise bond yields and attract demand to support its currency without having to hike short-term policy rates or expend foreign currency reserves. That said, there is risk to this strategy and a balance to strike. However, this might be an unappreciated positive among more than a few EM nations. Regrettably, a handful of EM nations are struggling to pay off their dollar debts and this seems to be monopolizing headlines. However, few reports recognize that many more EM countries have improved financial circumstances beneath the surface, setting up the potential for a significant upside surprise.
In summary, worries over dollar strength are a continued sign of pessimistic sentiment. Dollar strength is just one more of several concerns we’ve discussed this year, but like most fears, the impact is often far more minor than the media portrays, because outside of recessions, there is arguably no clear relationship between a strong dollar eroding exports and profits. There are brief times when a strong dollar coincided with temporary dips in exports and profits, but there are also extended periods when all have risen together (like in the 1990s). As that reality dawns on investors—fears will retreat, taking some of the attention off the dollar, which should help lift equities.