The risks of a stronger dollar

As the US dollar strengthens against other major currencies, investors may be overlooking the potential risks to markets and the economy

The volatility in US equity and bond markets stemming from the Federal Reserve’s move toward tighter monetary policy has made its way to global currency markets, with the US dollar soaring compared to global rivals.  So far this year, the dollar is up about 6.5% against a basket of other major currencies, having given up recently even stronger gains.  In what has been a notably broad move encompassing the currencies of the vast majority of economies, the dollar has risen a staggering 13.3% over the past 12 months, taking it to levels not seen in the past 20 years.

On paper, the appreciation of the currency of the world’s most resilient economic performer should help adjustments in the global economy.  It helps boost the exports of weaker countries while alleviating inflationary pressures in the US by lowering the cost of imports.  However, in the current conditions, the stronger dollar has far more complex implications on the wellbeing of an already wobbly global economy and for unsettled financial markets, making the path ahead riskier for investors, corporates and policymakers alike.

The typical investing playbook for a strong US dollar may not work well in today’s markets.  For instance, commodities  usually move inversely to the dollar, so theoretically we should see prices fall.  But his hasn’t been the case so far.  Instead, commodities-related inflation remains significant, due to the dual supply shocks caused by Covid-19 and Russia’s invasion of Ukraine.

A strong dollar also tends to bode ill for emerging markets that are dependent on dollar-denominated debt by making it harder for these regions to service this debt.  Today, however, many Emerging regions are in excellent fiscal shape, with plenty of foreign-exchange reserves.  In fact, those that supply fuel, fertiliser, food and metals, as is the case for much of Latin America, actually stand to benefit from the global supply squeeze.

The soaring dollar adds risks for the Fed as it seeks to tame inflation without slowing the economy into a recession.  In the near term, the stronger dollar may bolster the purchasing power of companies and consumers when it comes to imports, thus helping ease inflationary pressures.  But the dollar’s strength can also hurt US exports and the translation of overseas profits by US companies, posting headwinds to growth.  Only last Thursday, Microsoft joined a growing list of US companies revising their growth estimates down for 2022 in view of a strong US dollar.  Longer term, the currency’s strength may help further tighten financial conditions, just as the Fed is shrinking its balance sheet and international flows into the US market could be slowing in line with recoveries elsewhere.

In short, continued US dollar strength could complicate the outlook for the economy and markets, implications that may be under appreciated by investors at the moment.  Investors should keep an eye on real yield differentials for signs that the US dollar is peaking and consider rebalancing their international exposure, especially in low yielding instructions, where movements in the currency could have a significant impact on their overall return.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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