Double-Edged Dollar

Friday Reflection | July 22, 2022

Stocks rallied this week on incremental evidence that inflation is cooling, even as the consensus view is that market volatility isn’t yet behind us. The key headwinds of rising interest rates, an ongoing Russia-Ukraine war, a resurgent Covid wave, and sky-high energy prices have not been sufficiently resolved to soothe investors’ concerns. Despite this backdrop, the S&P 500 has gained more than 5% over the past month on resilient corporate earnings, although the stock index and most asset classes remain sharply lower than the price levels we saw at the start of the year.
 
One of the few assets that has experienced significant strengthening this year has been the US dollar. Amidst news of sweltering temperatures from London to Paris, the other major headline out of Europe this week was the US dollar reaching 1:1 parity with the Euro for the first time since the early days of the EU in 2002. While the Euro has gotten the most attention, the yen also sank to a 24-year low against the dollar in the past week.[1] In fact, over the past six months, the dollar has appreciated against almost every global currency.

As the world’s most widely-held reserve currency, the dollar often rises in times of economic turmoil as investors seek out relative safe havens for their capital. This flight to quality is an important component in the recent rise, but the bigger driver is a simple truth that money goes where money grows.
 
The US Federal Reserve has continued to hike interest rates faster and higher than many global counterparts. The result is that rates are now markedly higher in the United States than they are in many other large economies, boosting investor demand for US dollars and treasury bonds that can provide a safe yield. As money has poured in, the value of the dollar has increased.
 
The stark gap in interest rates eased slightly this week when the European Central Bank finally took decisive action. For weeks, ECB President Christine Lagarde had telegraphed that rates would rise gradually with quarter-point increases. In a surprise move on Thursday, the bank raised interest rates by a larger-than-expected half-percentage point and introduced new debt-relief measures for struggling economies in the European Union. The move takes the central bank’s key interest rate to zero, ending the bloc’s eight-year experiment with negative interest rates and capping two weeks of political and energy supply drama for Europe. The ECB’s decision brings it more into line with other central banks, including the Federal Reserve, underscoring that the bank’s top officials are increasingly worried about high inflation.
 
Even with the ECB’s increase, rates in the US still have a significant head start. The Fed Funds rate is expected to hit 3.5% heading into 2023, according to interest rate probability trackers. The current benchmark rate is at 1.75%, meaning the Fed is roughly halfway through its cycle of raising rates. How fast the Fed gets to its target, or if expectations stall before reaching it, will go a long way to determining when the dollar will peak against other foreign currencies.

If you are an American traveling or living abroard in Europe, you certainly appreciate that your dollars are going further and affording you greater purchasing power. Domestically, we also expect the stronger dollar to help bring down inflation by making imported goods cheaper for US consumers and companies. The most recent CPI data showed prices rose 9.1% over the past 12 months, so the Fed will welcome any help in the fight against inflation.
 
However, the effects aren’t all positive. A key downside to a stronger dollar is that American companies with large international operations are taking a hit when they convert foreign sales back into dollars. For example, profits at both Microsoft and Nike have recently eroded. Apple generates more than 60 percent of its sales outside the United States. In fact, 40% of all S&P 500 earnings come from abroad, which means that all else being equal, an 11% rise in the dollar this year has decreased S&P 500 profits by roughly 4.4%.[2] Corporate earnings calls are already citing headwinds from the dollar’s strength, and we expect this to continue as more companies reveal their latest financial results in the coming weeks.
 
Outside of the US, companies and governments regularly borrow in USD, which means higher debt costs when the dollar becomes more expensive versus local currencies. Paying interest to creditors in dollars has become particularly difficult for countries with rapidly depreciating currencies like Argentina and Turkey. Maurice Obstfeld, a professor of economics at UC Berkeley and the former chief economist for the International Monetary Fund, said a strong dollar can be particularly hard on poor countries, where it is correlated with declining demand and lower gross domestic product, as well as higher debt service costs.

The connotations of words such as “strong” and “weak” can mislead investors into believing that an appreciating currency is always a positive for the economy, but as we’ve shown the reality is more complex. Similar to other assets, currency markets have cycles and are sensitive to the near and intermediate-term outlook for the global economy. As inflation moderates in the coming months and the recession picture gains clarity, any signals that the Fed is shifting away from its current trajectory of aggressive rate hikes will be closely watched by investors.
 
In this period of elevated inflation and central bank posturing, currency hedging represents an interesting intersection between corporate earnings calls and personal planning. Just as corporate treasury teams look for opportunities or ways to reduce currency risk, if you’re planning a European vacation in the near future, you may want to convert some dollars to Euros now while the price is historically favorable. Taking this step won’t solve the current market volatility, but it can mean one less thing to worry about as you pack your suitcase and sunglasses and double-check your budget prior to departure.

Resources

[1] The Dollar Is Extremely Strong, Pushing Down the World NY Times

[2] S&P Revenues & the Economy, 7/18/22 Yardeni Research