Dollar deep dive – why it matters to stock markets and where does it go from here?

“Dollar Bills have absolutely no value except in our collective imagination, but everyone believes in the dollar bill.”

Yuval Noah Harari, Israeli historian and philosopher

As we move into the final quarter of this year, these words are ringing more true. The dollar has strengthened on a broad-basis, and the dollar index is up nearly 20% so far this year, its highest level since 2002.

The euro has dropped below parity versus the dollar, the Bank of Japan has been forced to intervene to strengthen the yen for the first time since the 1990s, and there’s been a full-blown crisis for sterling. Right now, everyone believes in the dollar bill, to the detriment of the rest of the foreign exchange (FX) market.

The dollar’s role as the world’s primary currency means that when it rallies, the impact is widespread. It’s not only having a major impact on the FX market, but it is also having a large impact on the global economy.

Here’s a closer look at why the dollar is rallying, what it means for investors, and what the endgame could be – after all, what goes up, must come down.

This article isn’t personal advice. If you’re not sure whether a course of action is right for you, ask for financial advice. Past performance is not a guide to the future.

Kathleen Brooks is Founder of Minerva Analysis, a market analysis company. Hargreaves Lansdown may not share the views of the author.

Why is the dollar so strong?

1. Haven status

The dollar is one of a few currencies that’s considered a ‘safe haven’. When the economy and geopolitical landscapes look worrying, people have tended to buy dollars.

The war in Ukraine, Russia’s threat to use nuclear weapons and surging levels of global inflation are driving demand into the dollar. As you can see in the chart below, which shows the Deutsche Bank FX Volatility Index, volatility spiked when Russia invaded Ukraine back in February.

Deutsche Bank FX Volatility Index, year-to-date

Past performance isn’t a guide to the future. Source: Bloomberg, 29/09/22.

However, the dollar’s status as a safe haven is complex. The US has lots of economic problems, not least the short-term nature of the funding for the US Federal Government.

At the end of September, the US Senate approved legislation to keep the Federal Government operating until mid-December. While the legislation easily passed the Senate 72-25, more than a third of senators voted against funding the Federal Government. Without the passage of this bill, a partial government shutdown would occur, yet this risk didn’t impact the FX market.

The dysfunctional nature of US politics isn’t supportive of the dollar’s status as a safe haven. Instead, technical factors also boost the dollar’s safe-haven credentials.

The dollar is the world’s most traded currency, which is another reason why people want to buy dollars in this environment. Looking at the chart below on a longer time frame, you can see dollar volatility has spiked during other periods of global crisis, such as the 2008 financial crisis.

Deutsche Bank FX Volatility Index, long-term chart

Past performance isn’t a guide to the future. Source: Bloomberg, 29/09/22.

2. The Federal Reserve’s strong dollar policy

The Federal Reserve (Fed) has responded to surging US inflation by hiking interest rates. US interest rates have risen to 3.25% since March this year. They’ve been increased at five consecutive meetings, including three consecutive 75 basis point hikes.

The Fed has rapidly changed course from its crisis-era policy of keeping rates at 0%, and it’s said it won’t stop until inflation is back towards the Fed’s target rate of 2%.

While other central banks are also raising rates, the US, along with Canada, have the highest interest rates in the G7, and further rate rises are expected. At the September meeting of the Federal Reserve, the rate setting committee’s median prediction for where interest rates would be in 2023 was 4.6%. This could well be revised higher in coming meetings.

In general, higher interest rates can impact the value of the currency versus countries that have lower interest rates. While there are multiple factors that drive a currency’s value, interest rates are one of the fundamental pillars of a currency’s strength. High interest rates combined with the dollar’s position as a safe haven, is a potent mix, and has driven the dollar index to appreciate the most year-to-date since 2000.

The dollar’s mega cycle

There are a number of reasons why the dollar could be in a mega cycle.

• USD reserve currency status – the dollar is the most widely held currency in the world. Key commodities are priced in dollars and the world couldn’t live without the dollar. Threats to its reserve currency status have dwindled in recent years. The euro has problems of its own, China’s increasingly isolated stance and zero-covid policy has made its chances of replacing the dollar as a reserve currency slim.
• US economic strength – the strong dollar is helping US purchasing power. This in turn is why the US growth outlook is better than that for other countries.
• Capital spending – US private fixed investment is a high share of gross domestic product (GDP), likewise, research and development spending in the US is at an all-time high. This massive boom in investment in recent years has helped to re-build the US economy since the financial crisis. It’s one of the reasons why the US has a brighter economic outlook compared to its peers in the G7.
• The USD and its innovation advantage – the slowdown of globalisation is also one reason why the dollar could continue to dominate FX markets. This will require more capital to be deployed domestically to replace international supply chains. Since the US is the world’s largest, and arguably the most innovative economy, there’s plenty of capital to be deployed. This is likely to be good news for long-term US economic strength and the dollar.

The impact of a mega cycle of dollar strength

Outside of the US, the strong buck is being blamed for two main reasons.

• Cost-of-living crisis – when your currency is weak against the dollar, lots of key imports become expensive, and this causes inflation to soar. This isn’t only a problem for emerging markets, it’s also a problem for the UK. The pound has dropped to a 40-year low versus the dollar, which is one of the reasons why the UK’s growth and inflation forecasts for the medium term are dismal.
• Risks of financial crises’ – in the worst-case scenario, the strong dollar could cause a financial crisis, especially in some emerging markets and those that have dollar-denominated debt. While dollar-denominated debt is far lower today than in other crises, there’s still $80bn of it around.

Sri Lanka and Pakistan have already called in the International Monetary Fund (IMF) due to financial difficulties. Added to this, now that central banks around the world are raising interest rates, the excesses of years of no interest rates could come home to roost.

The strong dollar and US asset prices

• The stock market – high levels of volatility in the FX market isn’t constructive for stock markets. That’s because the dollar has an inverse correlation with the main US stock market – as the dollar rises, stocks tend to fall.
• Company earnings – while the US dollar’s mega cycle could be a result of economic might, the strong dollar could hurt companies at home. On average, companies in the largest US stock index generate roughly 30% of their sales from abroad. If earnings are hit by the strong dollar, this could be bad news for the US stock market as we move into the final months of the year.

The endgame for the US dollar

If the USD is in a mega cycle, it could take some time for the dollar to fall. Here are some ways that the dollar could lose strength.

• Coordinated intervention risks – outside of the US, a strong dollar is now becoming a negative headwind for growth and for central banks around the world.

  The last time this happened in 1985, it led to a coordinated intervention from the US, UK, Germany, Japan and France to weaken the dollar, which is known as the Plaza Accord. At the time of writing, there’s no sign that a Plaza Accord 2.0 is on the cards. However, if US growth is impacted by the strong dollar in the coming months, then the probability of this happening increases.

• If other economies weaken sharply in the coming months, that isn’t good for the US economy and its trading partners, and it could have repercussions for the US down the line. Therefore, at some point, US authorities might start to support a weaker dollar, and the Fed could switch paths from fighting inflation to trying to protect growth. This could reduce the pace of rate increases and weigh on the dollar.
• If we do see a weaker dollar, then we could see other types of investments, notably stocks, begin to recover but there are no guarantees.