The U.S. dollar accounts for roughly 90 percent of foreign exchange transactions worldwide. As the world’s unofficial reserve currency, the dollar often appreciates in difficult times. This flight to safety characteristic in the current environment of high inflation, rising interest rates and geopolitical tension has resulted in strong dollar appreciation over the past year. A strong dollar has several important consequences for investors.
The U.S. Dollar Index (DXY) represents the value of the U.S. dollar relative to a collection of major foreign currencies: euro, Japanese yen, pound sterling, Canadian dollar, Swiss franc and Swedish krona. Over the past 50 years, the DXY has reached the current level three other times, as illustrated in the following graph. The first was in the early 1970s, a period of stagflation, high budget deficits, low interest rates and the infamous Oil Shock of 1973–74.
Source: Factset, 2022
The second period was during the 1980s, when DXY remained over 100 and peaked in 1985 at over 160. This period was marked by the emergence from the recession in 1982, when the U.S. economy rebounded after Paul Volcker, chair of the Federal Reserve (the Fed) broke the high inflation of the 1970’s. As the Fed started to cut rates, the ensuing strong GDP growth, high job creation and deficit spending propelled the economy. The dollar was buoyed by incoming flows until the 1987 stock market crash on Black Monday (October 19, 1987), when DXY depreciated back to historical lows. This period of a weaker dollar was sustained throughout the 1990s and saw DXY dip below the 80-index level in 1992.
The third period, from about December 1997 to March 2003, saw DXY rise back above the 100 level. While not a period of high inflation, it was a period where global challenges, such as the launch of the euro, Russian default and an emerging markets debt crisis, provided a backdrop for U.S. dollar safety.
Now here we are in 2022, with the dollar again back above the 100 level for a sustained period. The latest increases are rooted in the post-pandemic environment as the U.S. emerged strongly and earlier than most of the world.
To continue to illustrate the U.S. dollar’s strength, the following graph compares another dollar index, the ICE U.S. Dollar, to indexes of currencies of U.S. trading partners in other developed markets.
Source: Factset, 2022
In just one year, the dollar has appreciated almost 17 percent. It is interesting to note significant increases came after the first quarter of 2022, a period of increasing inflation, showing the dollar having a high correlation with inflation. The following graph shows that correlation. Albeit with a small sample size, this correlation could give some insight as to why the dollar strength has persisted as most of the world continues to battle inflation.
Source: Factset, 2022
This time frame also coincides with the Fed’s interest rate increases launched to combat inflation. Thus far, the Fed has been more proactive in raising interest rates than other major countries, which has played a role in the dollar's appreciation. When central banks like the Fed raise rates, higher-yielding Treasuries and other interest-rate products attract global investors. Those investors sell investments in their local currencies and buy USD-denominated products, pushing up the dollar. In addition, Russia’s invasion of Ukraine and high oil prices have put strain on European countries and their economies more so than it has on the U.S. As a result, the U.S. and the dollar are once again being sought after as a “safe haven.”
One consequence of the stronger dollar is that U.S. imports become cheaper, thus positively impacting consumer purchases. it also makes travel abroad for Americans relatively less expensive. The downside is the negative impact of a stronger dollar on the earnings of large U.S. multinational companies. In the most recent earnings season, companies with overseas operations are commenting that an extended period of a strong dollar will continue to impact earnings, and forward guidance from the Fed on rates is factoring in negative impacts due to the strong dollar.
U.S. multinationals aren’t the only ones hurt by continued strength in the dollar. Emerging market economies use the U.S. dollar to trade foreign goods. A strong dollar will increase both costs and the cost of debt repayments.
International investments held by U.S. investors will also be negatively affected by a declining exchange rate against the dollar. In addition, investors in emerging markets’ hard currency debt face higher credit risk, due to the rising cost of debt.
Overall, currency risk can hurt international equity returns in the short term, but it tends to even out in the long term. Most of the international equity funds and managers that Segal Marco Advisors reviews do not actively hedge currency risks. However, investment managers do take currency risk into account as part of their investment and risk-management processes as well as in reviews of underlying company fundamentals. But since the costs of hedging currency can be high, particularly when dealing with emerging markets, it is generally not part of international managers’ portfolios. Thus, if the strength of the U.S. dollar continues, it will be a headwind for investors. (However, for investors seeking to either fully or partially hedge out currency risk, there are currency-hedged products available.)
Currently, the dollar is at its highest levels in over two decades and has risen over 10 percent this year and 15 percent over the one-year period. While we continue to combat high levels of inflation and rising interest rates, the U.S. economy is still stronger than other economies. Thus, the U.S. dollar remains a haven in these turbulent markets. How long this strength persists remains to be seen.
Segal Marco Advisors provides consulting advice on asset allocation, investment strategy, manager searches, performance measurement and related issues. The information and opinions herein provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This article and the data and analysis herein is intended for general education only and not as investment advice. It is not intended for use as a basis for investment decisions, nor should it be construed as advice designed to meet the needs of any particular investor. Please contact Segal Marco Advisors or another qualified investment professional for advice regarding the evaluation of any specific information, opinion, advice, or other content. Of course, on all matters involving legal interpretations and regulatory issues, investors should consult legal counsel.
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