The Strong Dollar is a Blessing and a Curse

A strong dollar may be both a benefit and a burden, and it appears to be the latter at the moment. It is the first time in 20 years the euro and the U.S. dollar reached parity (meaning the value was the same). Although parity was fleeting, the dollar’s power versus the euro and other foreign currencies has remained stronger. Ed Yardeni, president of Yardeni Research, believes that global investors obviously prefer the dollar and dollar assets.

The U.S. Dollar Index (ticker: DXY), which compares the greenback to a basket of other currencies, is up almost 17% this year.

According to Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, dollar strength has been a critical feature of the post-Covid cycle. According to Shalett, the strong dollar surge has resulted in the currency acting as a protective shield for Americans suffering from decades of high inflation by increasing the American buying power of imports.

She adds that a strong dollar is often a counterbalance to global commodity prices since most commodities are priced in U.S. dollars, giving U.S. consumers and companies a significant advantage because the rest of the world must convert currencies to dollars to purchase items.

There are two variables primarily driving the dollar, and neither seems to be fading. According to Yardeni, one of the most significant threats looming over global financial markets is the Russia-Ukraine war and its influence on global food and energy supplies. Europe, in particular, is facing a huge energy crisis and severe recession, and Russia shut down about 89% of the gas flowing through the Nord Stream 1 pipeline.

Some analysts are concerned that gas supply through the critical European pipeline may completely halt. According to Deutsche Bank strategists, the uncertainty over whether Russia will or will not completely shut off Europe from its gas supply is a huge concern, as well as finding ways to replace the gas no longer flooding into Europe.

The second issue is global monetary policy. According to Jim Reid, Deutsche Bank’s head of credit strategy and thematic research, the widening interest rate disparity between the U.S. Federal Reserve and the European Central Bank. He points out that the former has already raised rates by more than 1.50% this year, but the latter has yet to raise rates despite consumer price inflation reaching historic highs.

The divergence between Fed and ECB policies appears destined to widen further after the June consumer price index hit a 40-year high. The statistics once again exceeded experts’ predictions and dashed hopes of peak inflation, with prices rising 9.1% yearly.

Additionally, the Fed raised interest rates again in July and September.

Meanwhile, The ECB has just started rising rates this month, with a 0.75% increase.

The Japanese yen is likewise falling in value versus the U.S. dollar. The rationale is also found in differing monetary policies. Yardeni of Yardeni Research points to Japan’s central bank’s vow to acquire as much government debt as necessary to keep the 10-year rate at or near zero.

Officials in the United States have historically and openly said that a strong currency is good for the country. Because America buys more than it sells, economists highlight the disinflationary element of a strong local currency.

And, as Yardeni points out, a strong currency implies relative optimism about the American economy amid what is expected to be a long period of a global downturn. The strong dollar may indicate that the United States will come out of this better than the rest of the globe, he adds.

However, there are drawbacks to a strong dollar, particularly one that is persistently so.

One is that the capacity of a strong currency to provide a buffer against inflation in the form of lower import prices is a double-edged sword. According to Morgan Stanley’s Shalett, the surging dollar increases risks for the Fed as it attempts to contain inflation, implying that the currency’s strength makes the central bank’s job of cooling demand more difficult.

This results in either tighter monetary policy or stagflation, in which high inflation continues, but growth slows significantly.

Second, there is the inverse of cheaper imports. The dollar’s strength harms U.S. exports and currency-translated foreign revenues of U.S. corporations, endangering economic development.

According to Shawn Cruz, chief trading strategist at T.D. Ameritrade, data from Morgan Stanley and Refinitiv show that every percentage point increase in the dollar results in around a half-point impact on earnings on the S&P 500. According to Cruz, a specific issue for the S&P 500 is that huge mega-cap international corporations are significantly weighted, with Alphabet (GOOG), Amazon (AMZN), Apple (AAPL), Meta (META), Microsoft (MSFT), and Netflix (NFLX) accounting for one-fifth of the index’s market capitalization. Some of these firms have previously issued warnings about currency headwinds, but Cruz argues that the issue affects practically every significant U.S. corporation.

In the long term, the dollar’s gain, according to Shalett, may help tighten financial conditions when the Fed is lowering its balance sheet after enormous recent bond purchases, and rate hikes may be more aggressive than investors previously thought. According to her, a strong dollar increases the likelihood of a recession that many accept as unavoidable.

According to Shalett, the final result is that the consequences of a higher dollar for financial markets and the economy are more complicated than many think, making the road ahead riskier for investors and policymakers.