Why is the US dollar so strong?
What does the strengthening of the dollar mean for investors, the global economy and inflation? The analysis by Stephen Dover, Chief Market Strategist and Head of Franklin Templeton Institute
The US dollar has been strengthening for 11 years now and this is the longest strengthening cycle of this currency ever. Over the past 15 months, the strengthening of the US dollar has accelerated. Since May 2021, the nominal broad US dollar index – which measures the trade-weighted value of the US dollar against other currencies in emerging or advanced economies – has grown by 10%. This is the biggest advance since 2014-2016 and has taken the index to its highest level since 2002.
Adjusted for differences in domestic inflation rates, the trade-weighted value of the US dollar has also risen sharply over the past year, continuing a trend that has already been underway for more than a decade. In terms of adjusted (real) inflation, the US dollar is now almost 30% higher than its 2010 levels.
Why is the US dollar so strong?
While many of the more recent comments regarding the strengthening of the US dollar focus on differences in monetary policy – for example, the Federal Reserve (Fed) has raised rates faster and more often this year than the European Central Bank – the The long period of strengthening of the US dollar over the past decade suggests that other factors also contributed significantly. Long-term exchange rate trends typically reflect persistent differences in economic growth rates and returns to capital. Over the past 15 years, since the onset of the global financial crisis, the US economy has grown faster, on average, than other major developed countries. Faster growth tends to attract foreign capital in search of higher returns. Much of this money went into US equity markets, which have consistently outperformed both developed and emerging markets since 2009.
Interest rate differentials also favored the US dollar; even during the protracted period of low interest rates and quantitative easing that followed the global financial crisis. While the Fed slashed interest rates after 2008, Europe and Japan went even further, driving bond rates and yields into negative territory.
Interest rate differentials widened towards the US dollar, strengthening it even more in 2022. Finally, the US dollar also benefited from its position as a “petro-currency”.
Unlike the eurozone, Japan or even China, which are heavily dependent on energy imports, the United States has become energetically self-sufficient in this century.
The impact of rising oil prices on the trade deficit has greatly improved in the United States as the country relies less on imported products, unlike many emerging markets which continue to depend on imports. The global upheavals in energy markets caused by Russia's invasion of Ukraine also had a positive net impact on the external value of the US dollar.
If we take into account the factors that have strengthened the US dollar in recent years, it is difficult to think that they will vanish anytime soon. The prolongation of the war between Russia and Ukraine (which now seems to have come to a standstill), the persistence of US inflation above the set target that prompts the Fed to decide further price hikes and little signs that other economies will perform better during the now inevitable global economic slowdown are all factors that suggest the dollar will remain strong.
What happens to growth, inflation and politics?
For the United States, the strengthening of the dollar makes exports more expensive and imports cheaper. This is one reason why the US current account deficit – the broader indicator measuring exports minus imports, including goods and services – has started to deteriorate again since 2019. his, slows the growth of gross domestic product (GDP) in the United States.
At the same time, the weakening of the euro, yen, pound or renminbi increases the competitiveness of the other major economies, supporting their economic activity. However, the impact of currency developments on broader growth indicators, such as GDP, can easily be overestimated. For larger economies, such as the United States, the eurozone as a whole, Japan or China, international trade typically accounts for less than a fifth of total output. In fact, around 80% of their economies are based on national activities. As a result, a strong US dollar alone is likely not likely to significantly worsen the growth outlook in the US. And not even a weak renminbi, euro or yen alone can revive the economies of China, Europe or Japan.
For similar reasons, currency developments are typically a "rounding error" with regard to inflation in major economies. Changes in import prices, including intermediate production, do not appear strongly in the final consumer price indices. In reality, for companies and individuals already in difficulty due to rising energy prices, the increased cost of importing oil or gas in euros or yen is another blow.
On the other hand, for smaller economies that are fairly open to trade, the weakness of their own currency can greatly contribute to increasing domestic inflation. This is particularly true for emerging economies which are more dependent on energy imports whose currencies have weakened against the US dollar. Furthermore, in a world where virtually every economy, developed or emerging, is faced with too high inflation, a strong US dollar tends to give monetary policy a tightening twist. This is because the increased impact on inflation of weak currencies outside the United States forces other central banks to hike even larger than they would otherwise decide.
In other words, for investors the first major implication of US dollar strength is not that it redistributes growth from the US to the rest of the world, but rather that it leads to increased monetary tightening in the rest of the world. For example, in Europe, despite the prospects for slow growth, the central bank has raised interest rates to fight high inflation. A strong US dollar, therefore, presents a greater risk to global growth.
How are capital markets affected?
Turning to capital markets, a consistently strong dollar will affect cross-border capital flows, the shape of yield curves, the cost of capital and the redistribution of profits.
Each of these elements can have major effects on returns by asset class, sector and investment style. While relative growth and stronger yields have led to a strengthening of the US dollar in recent years, the result is also a shift in relative valuations, particularly when adjusted for domestic purchasing power. Not only does the US stock market trade at a higher price-to-earnings ratio than its counterparties in the eurozone or Japan, but European or Japanese investors have become more expensive to buy shares of US companies in their home currency (more weak). As no tree in the forest grows forever, even on capital markets, at some point, value-oriented investors will start looking for more tempting investment opportunities. In our view, the end of US dollar strength will likely coincide with renewed interest in non-dollar assets.
As a strong US dollar tends to tighten global monetary policy, other likely outcomes will be a flattening or reversal of the yield curve as markets discount policy-driven rate hikes and a weakening of the yield curve. future growth. For equity investors this is typically a less than favorable situation for cyclical or value investment styles and more suited to quality or growth investments.
For fixed income investors, this can lead to unique duration opportunities. The strength of the US dollar, due among other things to high US inflation and the Fed's aggressive squeeze, will also tend to increase market volatility, both in terms of currencies and other asset classes.
This is simply what happens during major cyclical turning points. In that situation, broad currency movements can increase risk premia, leading to an increase in the cost of capital and a weakening of corporate spending and investments, thereby causing lower earnings and valuations. Foreign investors would also face additional currency hedging costs. Finally, a strong dollar tends to redistribute corporate profits, particularly for higher capitalization stock indices. For example, about one-third of the S&P 500's total corporate profits come from overseas and are denominated in other currencies. If the US dollar strengthens, US multinationals will convert these euro, yen or renminbi earnings into fewer dollars, thereby reducing profitability.
Meanwhile, the opposite is happening in Europe, Japan and the rest of the world: multinationals post better local currency profits thanks to the positive impact of US dollar profits converted into euros or yen.
What does this all mean?
So what can we conclude from the above? First, the reasons behind the impressive strengthening of the US dollar in 2022 and previous years don't seem to have much of a chance of disappearing anytime soon. Investors, policy makers and ordinary citizens will likely have to live with a strong dollar for a long time to come. Second, a strong US dollar is likely to have an asymmetrical impact on global growth given its impact on monetary policy. Global growth is likely to be weaker due to the strength of the US dollar. Third, the recent appreciation of the US dollar has been rapid and has contributed to the increased volatility of the capital and currency markets. Cyclical turning points like the one we are experiencing now tend to raise risk premia and, consequently, depress valuations. Fourth, in the medium term, a strong US dollar will tend to curb US inflation and growth while driving inflation and growth in the rest of the world instead. These opposite outcomes will eventually lead to a narrowing of the gap between the expected outcomes of monetary policy interventions around the world.
Similarly, the interest rate differentials that strengthened the US dollar this year may soon peak and provide the most support to the US dollar. Finally, a strong US dollar makes US assets expensive relative to foreign assets, prompting a reversal of cross-border capital flows. The same goes for profitability: the strength of the US dollar tends to reduce the profitability of US companies relative to foreign ones, leading to a reallocation of capital and capital flows that will eventually weaken the US dollar.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/dollaro-forte-cause-conseguenze/ on Sat, 08 Oct 2022 06:30:35 +0000.