Making Sense of the Dollar

Relative to other currencies around the world, the US dollar is strengthening. Its present value is at a multi-decade high due to the Fed’s tightening monetary policy, which seeks to effectively raise the cost of borrowing in a bid to slow red-hot inflation.

As the central bank hikes its target rate, global traders who would otherwise invest in foreign currencies become attracted to the more stable US dollar. It now delivers a similar rate of return with less associated risk. This process typically crushes the value of currencies in developing nations. It can also harm impoverished nations that must pay off debts in US dollars, or those that import food from the US.

Why This Time Is Different

As opposed to past instances where the dollar ran up in value, the current situation is putting less pressure on developing economies. On the one hand, central banks in emerging countries have maintained lower rates, making them a less attractive haven for investors to begin with. As such, not as much investment capital is being drained from those countries.

The other factor is the war between Ukraine and Russia, including how that’s upended European energy markets. You’d have to go back to 1985 to find a time when the British pound was this low relative to the US dollar. The Euro is at a 20-year low in comparison. Broadly speaking, with the threat of a recession elevated in Europe, investors have pivoted and poured cash into the dollar.

Both of these factors have helped the US dollar’s rise in comparison to other currencies.

The Broader Impact

It doesn’t seem the dollar’s run up in value is likely to abate anytime soon. Federal Reserve officials have indicated rate hikes will likely continue into next year. Meanwhile, the European Central Bank just enacted a 75-basis-point hike in a similar bid to fight inflation. The move also helps balance out the equation with regard to the Euro and US dollar.

At the same time, a stronger dollar is less than ideal for multinational companies that maintain a global footprint. During the most recent earnings season, a number of firms noted the stronger dollar harmed sales growth as a result of the unfavorable exchange rate. Taken together, the rise of the US dollar is multifaceted: the Fed and the Ukraine-Russia conflict may well determine how long it lasts.

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