“Dollar bills have absolutely no value except in our collective imagination, but everyone believes in the dollar bill.”
Yuval Noah Harari, Israeli historian and philosopher
As we enter the final quarter of this year, those words ring truer. The dollar has strengthened overall and the dollar index is up nearly 20% so far this year, its highest level since 2002.
The euro fell below parity against the dollar, the Bank of Japan was forced to intervene to strengthen the yen for the first time since the 1990s and the pound sterling experienced a real crisis. Right now, everyone believes in the dollar bill, to the detriment of the rest of the foreign exchange (FX) market.
The dollar’s role as the world’s main currency means that when it recovers, the impact is widespread. This not only has a major impact on the forex market, but it also has a big impact on the global economy.
Here’s a closer look at why the dollar is rallying, what that means for investors, and what the endgame could be – after all, what goes up must come down.
This article is not personal advice. If you are unsure whether a course of action is right for you, seek financial advice. Past performance is not indicative of the future.
Kathleen Brooks is the founder of Minerva Analysis, a market analysis company. Hargreaves Lansdown may not share the views of the author.
Why is the dollar so strong?
1. Refuge status
The dollar is one of the few currencies considered a “safe haven”. When the economy and geopolitical landscapes look ominous, people tend to buy dollars.
The war in Ukraine, Russia’s threat to use nuclear weapons and soaring global inflation are pushing demand towards the dollar. As you can see in the chart below, which shows the Deutsche Bank FX Volatility Index, volatility peaked when Russia invaded Ukraine in February.
Deutsche Bank FX Volatility Index, year-to-date
Past performance is not indicative of the future. Source: Bloomberg, 9/29/22.
However, the status of the dollar as a safe haven is complex. The United States has many economic problems, including the short-term nature of US federal government funding.
In late September, the US Senate approved legislation to keep the federal government operating until mid-December. While the legislation easily passed the Senate 72-25, more than a third of senators voted against federal funding. Without the passage of this bill, a partial government shutdown would occur, but this risk has not impacted the forex market.
The dysfunctional nature of US politics does not support the safe haven status of the dollar. Instead, technical factors are also bolstering the dollar’s safe-haven credentials.
The dollar is the most traded currency in the world, which is another reason why people want to buy dollars in this environment. Looking at the chart below over a longer timeframe, you can see that dollar volatility has increased during other times of global crisis, such as the 2008 financial crisis.
Deutsche Bank FX Volatility Index, long term chart
Past performance is not indicative of the future. Source: Bloomberg, 9/29/22.
2. The Federal Reserve’s strong dollar policy
The Federal Reserve (Fed) reacted to soaring US inflation by raising interest rates. US interest rates have risen to 3.25% since March of this year. They have been increased in five consecutive meetings, including three consecutive increases of 75 basis points.
The Fed has quickly changed course from its policy of keeping rates at 0% during the crisis, and it is said that it will not stop until inflation returns to the target rate of 2 % Fed.
While other central banks are also raising rates, the United States, along with Canada, has the highest interest rates in the G7, and more rate hikes are expected. At the Federal Reserve’s September meeting, the rate setting committee’s median forecast for the interest rate position in 2023 was 4.6%. This may well be revised upwards in future meetings.
In general, higher interest rates can impact the value of the currency compared to countries that have lower interest rates. Although there are multiple factors that determine the value of a currency, interest rates are one of the fundamental pillars of a currency’s strength. High interest rates combined with the dollar’s position as a safe haven is a powerful mix and has led the dollar index to appreciate the most since the start of 2000.
The dollar mega cycle
There are a number of reasons the dollar could be in a mega cycle.
- USD reserve currency status – the dollar is the most widely held currency in the world. Major commodities are valued in dollars and the world could not live without the dollar. Threats to its reserve currency status have diminished in recent years. The euro has its own problems, China’s increasingly isolated position and its zero covid policy have reduced its chances of replacing the dollar as a reserve currency.
- Economic power of the United States – the strong dollar supports American purchasing power. This is why the growth prospects in the United States are better than those of other countries.
- Capital expenditure – Private fixed investment in the United States represents a high share of gross domestic product (GDP), as well as research and development spending in the United States is at an all-time high. This massive investment boom in recent years has helped rebuild the US economy since the financial crisis. This is one of the reasons the United States has better economic prospects than its G7 counterparts.
- The USD and its innovation advantage – the slowdown in globalization is also one of the reasons why the dollar could continue to dominate the foreign exchange markets. This will require more capital to be deployed domestically to replace international supply chains. Given that the United States is the largest economy in the world, and arguably the most innovative, there is a lot of capital to deploy. This is probably good news for long-term US economic strength and for the dollar.
The impact of a mega cycle of dollar strength
Outside the United States, the strong dollar is blamed for two main reasons.
- Cost of living crisis – when your currency is weak against the dollar, many key imports become expensive, driving up inflation. It’s not just a problem for emerging markets, it’s also a problem for the UK. The pound has fallen to its lowest level in 40 years against the dollar, which is one of the reasons why the UK’s medium-term growth and inflation forecasts are dismal.
- Risks of financial crises’ – in the worst case, the strong dollar could cause a financial crisis, especially in certain emerging countries and those with debt in dollars. While dollar-denominated debt is much lower today than in other crises, there is still $80 billion of it.
- The stock market – high levels of volatility in the foreign exchange market are not constructive for the stock markets. This is because the dollar has an inverse correlation with the main US stock market – when the dollar goes up, stocks tend to go down.
- Company income – while the US dollar mega cycle could be the result of economic power, the strength of the dollar could hurt businesses at home. On average, companies in the largest US stock index make about 30% of their sales abroad. If earnings are hit by dollar strength, this could be bad news for the US stock market as we enter the final months of the year.
- Coordinated intervention risks – outside of the US, a strong dollar is now becoming a headwind for growth and for central banks around the world.
The last time this happened in 1985, it led to a coordinated intervention by the US, UK, Germany, Japan and France to weaken the dollar, known as the ‘Plaza Agreement. As of this writing, there’s no indication that a Plaza Accord 2.0 is on the cards. However, if US growth is impacted by the strong dollar in the coming months, then the likelihood of this happening increases.
- If other economies weaken sharply over the next few months, that’s not good for the US economy and its trading partners, and it could have repercussions for the US down the road. Therefore, at some point, US authorities may start supporting a weaker dollar, and the Fed may switch from fighting inflation to trying to protect growth. This could reduce the pace of rate hikes and weigh on the dollar.
- If we see a weaker dollar, then we could see other types of investments, including stocks, start to rally, but there are no guarantees.
Sri Lanka and Pakistan have already appealed to the International Monetary Fund (IMF) due to financial difficulties. On top of that, now that central banks around the world are raising interest rates, the excesses of interest-free years could reverberate.
The strong dollar and US asset prices
The Endgame for the US Dollar
If the USD is in a mega cycle, it could take a while for the dollar to fall. Here are some ways the dollar could lose strength.