The U.S. Dollar Index is up about 17% so far this year.
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A strong dollar can be both a blessing and a curse, and at this point, it is looking more like the latter.
The exchange rate between the euro and the U.S. dollar this week hit parity, where the two currencies were worth the same amount, for the first time in 20 years. Parity was brief, but the dollar’s strength against the euro and other foreign currencies isn’t.
“It’s a risk-off world we’re living in,” says Ed Yardeni, president of Yardeni Research. “Global investors are clearly favoring the dollar and dollar assets.”
So far this year, the U.S. Dollar Index (ticker: DXY), which compares the greenback to a basket of other currencies, is up about 17%.
As Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management puts it, dollar strength has been a major characteristic of the post-Covid cycle. The aggressive dollar rally has meant the currency has acted as a protective shield for Americans suffering from decades-high inflation, Shalett says, as it amplifies American purchasing power of imports.
She says a strong dollar is also typically a counterweight to global commodity prices because most commodities are priced in U.S. dollars—meaning U.S. consumers and businesses have a big advantage as the rest of the world has to convert currency to dollars to buy commodities.
There are two main factors driving the dollar. Neither look like they are about to fade.
One of the biggest risks hanging over global financial markets is the war in Ukraine and its impact on worldwide food and energy supply, says Yardeni.
Europe in particular faces a significant energy crisis and severe recession, and odds of such a crisis and economic downturn shot higher during the week after Russia shut down the Nord Stream 1 pipeline for maintenance work.
Some strategists have expressed concerns that gas deliveries through the crucial European pipeline won’t be resumed. Strategists at Deutsche Bank say that ambiguity over whether Russia will or won’t fully cut Europe off from its gas may linger until early August.
Second is global monetary policy. Jim Reid, Deutsche Bank’s head of credit strategy and thematic research, points to the growing divergence in interest rates between the U.S. Federal Reserve and the European Central Bank. The former, he notes, has already hiked by 1.50% this year, while the latter hasn’t started raising rates even as consumer price inflation hits record highs.
The gap between Fed and ECB policy looks set to grow even wider after the June consumer price index, released Wednesday, showed a new 40-year high. The data again blew out economists’ expectations and crushed hopes of peak inflation as total prices rose 9.1% from a year earlier.
Before the release, data from CME showed traders put 90% odds on another 0.75% interest rate hike when the Fed’s next meeting ends on July 27. After the CPI report, traders swiftly changed bets and now see a 51% chance of a full point hike this month.
Meanwhile, Reid notes that the ECB is likely to just begin its hiking cycle this month, and with a much smaller 0.25% move.
The Japanese Yen is also collapsing against the dollar. There, the explanation also lies in diverging monetary policy. Yardeni of Yardeni Research points to so-called yield curve control, where Japan’s central bank has pledged to buy as much government debt to keep the 10-year yield at or near zero.
U.S. officials have traditionally and publicly maintained that a strong dollar is good for the U.S. Economists emphasize the disinflationary aspect of a strong domestic currency, since America imports more than it exports.
And as Yardeni says, the strong dollar reflects relative optimism over the American economy during what is likely to be a protracted period of global weakness.
“The strong dollar in my mind signals the U.S. can get through this in better shape than the rest in the world,” he says.
But there are downsides to a strong dollar, especially one that is relentlessly so.
One is that the strong dollar’s ability to provide a cushion against inflation, in the form of cheaper imports, is a double-edged sword. The soaring dollar adds risks to the Fed as it tries to tame inflation, Morgan Stanley’s Shalett says, meaning the currency’s strength is making the central bank’s job of cooling demand harder.
That sets up either even tighter monetary policy or stagflation, where high inflation persists as growth meaningfully slows.
Second is the flip side of cheaper imports. The dollar’s strength hurts U.S. exports and currency-translated overseas profits of U.S. companies, in turn threatening economic growth.
Shawn Cruz, head trading strategist at TD Ameritrade, says data from Morgan Stanley and Refinitiv shows that on a year-over-year basis, every percentage point gain in the dollar results in about a half point hit to earnings on the S&P 500.
A particular problem for the S&P 500, says Cruz, is that major megacap multinational companies are weighted heavily—with Alphabet (GOOG), Amazon (AMZN), Apple (AAPL), Meta (META), Microsoft (MSFT), and Netflix (NFLX) making up a fifth of the index’s market capitalization. Some of those companies have already warned about currency headwinds, but Cruz notes the issue touches virtually every large U.S. company.
Longer term, Shalett says, the dollar’s strength may help further tighten financial conditions just as the Fed is shrinking its balance sheet after massive pandemic bond purchases and as rate increases potentially remain more aggressive than investors previously anticipated. The strong dollar thus increases the odds of recession, she says, something that many investors have come to see as inevitable.
The bottom line, Shalett says: the implications of a stronger dollar for financial markets and the economy are more complex than many realize, making the path ahead riskier for investors and policy makers alike.
Write to Lisa Beilfuss at lisa.beilfuss@barrons.com
Source: barrons.com
