The Strong Dollar: What it Could Mean for Investors
The value of the US dollar has risen sharply in 2022 compared to currencies of many other countries including the British pound, the Japanese yen, the Canadian dollar and the euro. The dollar is at its highest level in 20 years against other major currencies, while the pound is at its lowest level against the dollar since 1985.
Exchange rates made the news earlier in 2022 when the British pound and USD reached parity, meaning they exchanged 1:1. It begs the question, how can currency movements impact consumers, businesses and investors?
What Does a “Strong Dollar” Mean?
A strong dollar means that the US dollar has risen in value relative to other currencies in the foreign exchange market. In simple terms, it means that the US dollar can now buy more of a foreign currency than before. The terms strengthening and weakening both refer to changes in the value of the US dollar over a period of time.
Why Do Currencies Rise and Fall?
To understand the impacts of a strengthening dollar, it’s helpful to know how currencies are valued. The foreign exchange market is open 24/7 and exchange rates are always moving. Over the short-term, currency fluctuations can be severe, even if they are stable over the long-term.
Supply and Demand
The foreign exchange market behaves similarly to the rest of the stock market, where the market value of currencies fluctuates based on basic forces of supply and demand.
Fluctuating currency values reflect how much the governments, companies, banks and individual forex investors are willing to pay. Their views on the relative values of currencies mostly reflect where they believe they will get the best return on their investment.
Typically, if a country has relatively strong economic growth and low debt, its currency will be sought after in global markets, which will cause its price to rise.
On the other hand, countries whose growth is weak and debt is high will tend to see less demand for their currencies and, in turn, their value will lag behind those of countries with stronger economies.
“Safe Haven” Assets
Economic growth is only one piece of the puzzle. Emerging market economies may have strong long-term growth prospects, such as Brazil or India, but their currencies are not as highly valued by global investors. That’s because their economies rely heavily on a few industries or commodity exports, which leaves them more vulnerable to boom and bust cycles.
Like other market prices, there is not just one variable that goes into the valuation of currencies. Because prices are determined by supply and demand, they rely on investor speculation about the future of global economies. Investors can determine how much they are willing to pay for a foreign currency.
Why Is the US Dollar Strengthening in 2022?
While almost every asset class has seen dismal returns in 2022, the US dollar has strengthened dramatically over the course of the year. The US Dollar Index, which measures USD against a basket of other currencies, is up 17% from January to October 2022.
The dollar’s strength is even more pronounced when compared to the poor performance of stocks, bonds and cryptocurrencies.
The greenback, a colloquial term for USD used by foreign exchange traders, is strengthening in large part due to monetary policy. The Federal Reserve has adopted a hawkish stance in response to sky-high inflation.
That means the Fed has taken on the steepest rate hike schedule in decades, bringing the fed funds rate from near zero at the beginning of 2022 to a range of 3.0%-3.25% at the September FOMC meeting.
In addition to monetary policy, the USD has strengthened because of the comparison to how other countries are managing high inflation and recession fears. While the US has many economic indicators signaling a recession, it’s still looking much stronger than other advanced economies.
European economies have had to bear the brunt of Russia’s war on Ukraine, especially in the form of dramatically higher energy costs. Japan is struggling with lower global demand for manufactured goods, which make up a large portion of its exports.
Other geopolitical risks have also harmed other countries more than the US. China is experiencing economic trouble due to its strict pandemic lockdown policies and bursting real estate bubble. All these global risks have driven investors to safe-haven investments — the greenback is considered one of the safest bets around.
Who Can Benefit From a Strong Dollar?
A strong dollar is good for some and relatively bad for others, depending on where you live and how you spend your money.
Americans Traveling Abroad
US residents can see their dollars go further abroad, providing greater purchasing power when traveling overseas. Because the strong US dollar is measured relative to other countries, those dollars can buy more goods when converted to the local currency of a foreign country.
Consumers of Foreign Imports
Goods produced abroad and imported to the United States will be cheaper if the manufacturer’s currency falls in value compared to the dollar. For example, luxury cars from Europe, such as BMWs and Ferraris, could fall in dollar price, making them more affordable to US consumers.
Other lower-cost imports tend to also fall in price, leaving more disposable income in the pockets of American consumers. US companies that import raw materials from abroad will have a lower total cost of production and see larger profit margins as a result.
Multinationals That Do Business in the US
Foreign companies that do a lot of business in the US and investors in those companies will benefit from a stronger dollar. Multinational corporations that make a lot of sales in the US, and thus earn income in dollars, will see gains in the dollar translate to gains on their balance sheets.
Investors in these companies tend to be rewarded as well as profit margins increase.
Status of the US Dollar
The US dollar is considered the world reserve currency and this status is only heightened with a strong dollar. While some countries, including Russia, Iran, and China have questioned the status of the US dollar as the de facto world reserve currency, a strong dollar helps keep its demand as a reserve high.
Who May Be Hurt by a Strong Dollar?
Tourists Visiting the US
Visitors from abroad will find prices of goods and services in the US more expensive because of a worsened exchange rate from their local currency. Business travelers and foreigners living in the US but holding on to foreign-denominated bank accounts, or who are paid incomes in their home currency, will see their cost of living increase.
If the cost of tourism rises too much, the US could see a decline in the industry as fewer and fewer people can afford it. Tourism represents a large portion of many local economies, so the economic fallout of too strong of a dollar could be large.
Just as imports become cheaper at home, domestically produced goods become relatively more expensive abroad. It can be argued that expensive exports can cost American jobs as demand for American-made items declines.
US Companies Conducting Business Abroad
Companies based in the US that conduct a significant amount of business abroad will suffer as the income they earn from foreign sales decreases in value. Investors in such companies are also likely to see a negative impact.
For example, Microsoft Corp (MSFT), the world’s third most valuable company by market cap, has warned economists and investors that future revenue is expected to drop thanks to a rising US dollar.
This is because MSFT takes roughly half of its revenues in foreign currencies. If the value of the money earned abroad declines compared to the dollar, Microsoft will earn less in US dollars for those sales.
Emerging Market Economies
Many emerging market countries issue dollar-denominated debt and then service those IOUs with their local currency. If the dollar is strengthening and interest rates are rising, that could potentially lead to losses and defaults in those countries.
How Can a Strong Dollar Impact Investments?
Volatility in the currency market can have a major impact on US investors, especially for those with allocation in foreign or multinational companies. An unfavorable exchange rate diminishes returns from these companies.
When portfolio managers convert dollars into cheaper local currencies to buy foreign securities on local exchanges, it drives the daily net asset value of the fund lower. In addition, emerging-market bond funds that issue dollar-denominated debt face the additional risk of higher repayment costs and an increased risk of potential default.
Individual companies with outsized exposure to overseas markets tend to see less demand for their products, which rise in price and become more expensive than those of their local competitors.
Since mid-2022, US-based companies such as Coca-Cola (KO), Procter & Gamble (PG), Philip Morris (PM) and Microsoft (MSFT) have lowered profit expectations based on a rising dollar value.
How Can Investors Hedge for Exchange Rate Volatility?
There are a few strategies that allow individual investors to hedge against currency fluctuations, but most tend to be complex and expensive. Average traders need to be aware of global events in order to understand why their portfolio may be struggling at a particular moment.
Currency hedging is similar to hedging of any other asset. Investors hedge with currency in an attempt to reduce the effects of currency fluctuations on investment performance.
To hedge an investment, investment managers will set up related currency investments designed to offset changes in the value of your home currency. In general, currency hedging reduces the volatility in the value of an investment due to changes in the exchange rate.
The Bottom Line
Depending on your investment portfolio allocation, a strong dollar can be beneficial or harmful for returns. The foreign exchange market is more complex than other, more traditional markets, which can make forecasting future currency movements difficult.
Investors should be aware of who is impacted the most by changes in exchange rates and understand how that impacts your portfolio, but keep in mind that the forex market is one of the most volatile markets. There are bound to be large fluctuations, by the nature of the market. Those fluctuations do not necessarily signal any future values.