Is the strength of the dollar a blessing and a curse?

A strong dollar can be both a blessing and a curse, and is more like the latter at the moment.

EUR/USD chart at 1-week intervals

The exchange rate between the euro and the US dollar reached parity this week for the first time in 20 years. Parity was short-lived, but the strength of the dollar against the euro and other foreign currencies was not.

“We live in a risk-free world,” says Ed Yardeni, president of Yardeni Research. “Global investors are clearly favoring the dollar and dollar-denominated assets.”

So far this year, the US dollar index, which compares the dollar to a basket of other currencies, is up about 17%.

As Lisa Shalette, chief investment officer at Morgan Stanley Wealth Management, says dollar strength has been a key feature of the post-Covid cycle. The dollar’s aggressive rally has meant the currency has acted as a shield for Americans suffering from the highest inflation in decades, Shalette says, as it boosts the purchasing power of US imports.

She says that a strong dollar also tends to be a counterbalance to global commodity prices because most goods are priced in US dollars, which means US consumers and businesses have a big advantage as the rest of the world has to convert currencies into dollars for purchases of goods.

There are two main factors that determine the dollar exchange rate. Neither look like they’re about to disappear.

According to Yardeni, one of the biggest risks looming over global financial markets is the conflict with Ukraine and its impact on global food and energy supplies.

Europe in particular is facing a significant energy crisis and a severe recession, and the likelihood of such a crisis and economic downturn has risen sharply since Russia closed the Nord Stream 1 pipeline for repairs.

Some strategists have expressed concern that gas deliveries through Europe’s key pipeline will not resume. Deutsche Bank strategists say that uncertainty over whether or not Russia will cut Europe off completely from gas could linger until early August.

The second is global monetary policy. Jim Reid, head of credit strategy and case studies at Deutsche Bank, points to the growing interest rate divergence between the US Federal Reserve and the European Central Bank.

The Fed has already raised rates by 1.50% this year, while the ECB has yet to start raising rates even as consumer price inflation hit record highs.

The gap between Fed and ECB rates looks set to widen even further after the June CPI, released on Wednesday, hit a new 40-year high. The data again beat economists’ expectations and shattered peak inflation hopes as the overall consumer price index rose 9.1% from the previous year.

Before the release of inflation data, the money market showed that traders in Fed Funds futures were betting 90% on another 0.75% interest rate hike on July 27. After the release of the inflation report, traders quickly changed rates and now see a 51% chance of a 1% rate hike this month.

Meanwhile, Reed notes that the ECB will likely only begin its rate hike cycle this month, and in much smaller increments of 0.25%.

The Japanese yen is also falling against the dollar. Here, too, the explanation lies in differences in monetary policy. Yardeni of Yardeni Research points to so-called yield curve control, when Japan’s central bank promised to buy unlimited amounts of government debt to keep 10-year bond yields below 0.25%.

US officials have traditionally and publicly argued that a strong dollar is good for the US economy. Economists highlight the disinflationary aspect of a strong national currency as America imports more than it exports.

And, Yardeni says, a strong dollar reflects relative optimism about the US economy during what is likely to be an extended period of global slowdown.

“A strong dollar, in my opinion, signals that the US can get through this period in better shape than the rest of the world,” he says.

But a strong dollar also has its downsides, especially if it appreciates inexorably.

One is that the ability of a strong dollar to provide inflation protection in the form of cheaper imports is a double-edged sword. Morgan Stanley’s Shalett said a stronger dollar adds risks to the Fed as it tries to curb inflation, meaning that a stronger currency makes it harder for the central bank to cool demand.

This leads to either even tighter monetary policy or stagflation, where high inflation persists and economic growth slows significantly.

Secondly, this is the flip side of cheaper imports. A stronger dollar hurts US exports and foreign-denominated profits of US companies, which in turn threatens economic growth.

Sean Kruse, chief trading strategist at TD Ameritrade, says data from Morgan Stanley and Refinitiv shows that on an annualized basis, every percentage point of the dollar’s gains reduces S&P 500 earnings by about half a point.

A particular problem for the S&P 500, Cruz said, is that large, large-cap multinationals carry a lot of weight: Alphabet (GOOG), Amazon (AMZN), Apple (AAPL), Meta (META), Microsoft (MSFT) and Netflix (NFLX) make up one fifth of the index’s capitalization. Some of these companies have already warned of currency headwinds, but Cruz notes that this problem affects virtually every major US company.

In the longer term, Schalette said a stronger dollar could further tighten financial conditions as the Fed cuts its balance sheet after massive pandemic bond purchases and as rate hikes potentially remain more aggressive than investors previously expected. Thus, a strong dollar increases the likelihood of a recession, she says. Many investors already see a US recession as inevitable.

The implications of a stronger dollar for financial markets and the economy are more complex than many realize, Schalette said, making the road ahead more risky for investors and policy makers alike.

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