Why Does the Strength of the US Dollar Matter?
What the rising strength of the US Dollar means for the economy.
The US Dollar (USD)
The strength or weakness of the US Dollar plays an important role in the world economy. The strength of USD is dependent on the demand for USD; meaning that the more foreign countries want the goods the US produces or the financial services and institutions the US offers, the stronger the dollar becomes relative to foreign currencies. When the US prints more money like they did in 2020 during the pandemic, the value of the dollar decreases, causing a decrease in the value of the dollar.
Right now, the Federal Reserve is tightening monetary policy, taking money out of the financial system. This helps increase the strength of the dollar, especially if other countries are not tightening as much as the US. Along with this, the Euro is decreasing in strength due to the war in Ukraine, over energy and severe recession concerns in Europe.
The Inflation Conversation and Pasta!
As with every economic discussion in the last year, we have to talk about the impact on inflation. A stronger US Dollar is deflationary for the United States, but inflationary for other currencies. Here’s an example:
Let’s say we are in a situation like we are now, Strong USD compared to the Euro. Importing pasta from Italy becomes cheaper for the United States because each one of their USD is worth more Euro than it used to be. This means the United States is getting more pasta per dollar than before. On the flip side, this has become much more expensive for Italy, who is exporting the pasta. This means Italy is earning less pasta per dollar because exports have become more expensive due to a stronger dollar. Italy is receiving less Euro than they were before for the same amount of pasta, which means they will have to raise prices in response to a stronger dollar.
This basically means that the United States having a stronger dollar than other countries can help bring down the high levels of inflation we are seeing here, but has to potential to make the inflation situation much worse for other countries.
Just How Strong is the US Dollar?
This chart below shows DXY, the United States Dollar Index, Year-To-Date Performance. As you can see, USD started the year just above 95, and has risen all the way to over 107 at the time of writing this. That is an over 11% increase in the first half of the year for the US Dollar. In contrast, the Euro is the weakest it has been in 20 years compared to the US Dollar, due to high gas prices and fears over a “deep” recession in Europe.
According to my scrolling back on Webull, the US Dollar Index is the highest it has been since 2002. Before this point, the Dollar was much stronger, with 107 being a general weak point before. In terms of historically, the Dollar is not as strong as it used to be. But using our recency bias, the Dollar is as strong as it has been in my lifetime.
Why has it been weaker in recent years? Monetary Policy. Looser monetary policy following the dot com bubble, then the 2008 financial crisis and Great Recression, and then the COVID-19 shutdown caused massive amounts of fiscal stimulus and a generally more accomodative Federal Reserve. Also stronger currencies in China and other foreign countries have stepped up, lessening the importance of the Dollar.
USD and The Stock Market
Let’s compare the chart of the Dollar, DXY, to the S&P 500 year-to-date:
As you can see, in 2022, as the Dollar, DXY, has increased, the S&P 500 has decreased. This has lead many short term traders to think that the dollar and stocks has an inverse relationship, but is this true? Not quite.
For the past twenty years, the rise in value of USD has had a slight positive correlation to the movement of the S&P 500. In the short term, we have seen a negative correlation between USD and S&P 500. In the long run, it is safe to say there is not much correlation between stocks and the USD. This could be proven wrong in a scenario where USD collapses, as that would most definitely crash the stock market, but this is highly unlikely in the near future.
What To Expect From The Strong Dollar
The stronger dollar is not the end to high inflation, but we could start seeing a decrease in some areas of inflation if the dollar maintains its current strength. We may also see companies with large international business have their profits decrease, as foreign exchange headwinds will cut into margins. A stronger dollar will also make it more difficult for consumers outside the United States to maintain their purchasing power. From an investment perspective, emerging market investments tend to underperform with a strong dollar, as companies have to pay more to obtain their USD reserves. While the US can benefit from a stronger currency, it can hurt economies worldwide.