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Volatility in US stock and bond markets stemming from the Federal Reserve’s monetary policy tightening spilled over into global currency markets, with the US dollar surging against its global rivals. So far this year, the dollar is up around 6.5% against a basket of other major currencies, having recently given up even bigger gains. In what has been a particularly broad movement encompassing the currencies of the vast majority of economies, the dollar has risen 13.3% in the past 12 months, taking it to levels not seen in the past 20 years.
On paper, the appreciation of the currency of the best performing economy in the world should support adjustments in the global economy. It helps boost exports from weaker countries while easing inflationary pressures in the United States by lowering the cost of imports. However, under current conditions, the strengthening dollar has far more complex implications for the well-being of an already shaky global economy and unstable financial markets, making the way forward riskier for investors, businesses and policy makers.
The typical investment playbook for a strong US dollar may not work well in today’s markets. For example, commodities generally move inversely to the dollar, so theoretically we should see prices fall. But this is not the case so far. Instead, commodity inflation remains significant, due to the twin supply shocks caused by Covid-19 and Russia’s invasion of Ukraine.
A strong dollar also tends to bode badly for emerging markets that rely on dollar-denominated debt by making it harder for those regions to service that debt. Today, however, many emerging regions are in excellent fiscal shape, with ample foreign exchange reserves. In fact, those who supply fuel, fertilizers, food and metals, as is the case for much of Latin America, should actually benefit from the contraction in global supply.
The soaring dollar adds risks for the Fed as it seeks to rein in inflation without dragging the economy into a recession. In the short term, the appreciation of the dollar could strengthen the purchasing power of businesses and consumers with regard to imports, thus helping to reduce inflationary pressures. But the strong dollar can also hurt US exports and the translation of US corporate earnings abroad, which dampens growth. Just last Thursday, Microsoft joined a growing list of U.S. companies revising their 2022 growth estimates downward in light of a strong U.S. dollar. Longer term, currency strength could help further tighten financial conditions, just as the Fed shrinks its balance sheet and international flows into the US market could slow in line with recoveries elsewhere.
In short, the continued strength of the US dollar could complicate the outlook for the economy and markets, implications that may be underestimated by investors at this time. Investors should keep an eye on real-yield differentials for signs that the US dollar is nearing a top and consider rebalancing their international exposure, especially in low-yield statements, where movements in the currency could have a negative impact. significant impact on their overall performance.
Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is published by Calamatta Cuschieri Investment Services Ltd and is authorized to engage in investment services business under the Investment Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.
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