“King Dollar” Is Losing Its Luster

Posted on Dec 18, 2020 in Monetary Policy

“King Dollar” Is Losing Its Luster

Following several years of relative strength, the US dollar has weakened rather precipitously since the early stages of the coronavirus outbreak. While many economists think it’s a good sign that the dollar is pulling back (and it certainly can be), it’s not an unambiguous positive. In normal times, currencies will fluctuate based on a wide variety economic and other factors, each of which needs to be considered not in isolation, but relative to other countries. These factors include prospects for economic growth and stability; attractiveness of investment opportunities; the level of interest rates; inflation and inflation expectations; trade balances; fiscal and monetary policy; political stability; and the currency’s perceived value as a safe haven in times of distress. Like all other currencies, the dollar fluctuates based on these factors and how they affect the supply of and demand for any specific currency.

But the US dollar is also unique in one respect. The US dollar benefits from its status as the dominant reserve currency for the world. This basically means that foreign governments and central banks keep large stores of dollars on hand in order to engage in cross-border transactions and investments. It also means that a large chunk of global commerce, including the settlement of most commodity trades, is done in US dollars. The US dollar gained this status because we Americans have the largest and most dynamic economy in the word, with a dominant position in the global financial markets. The willingness to hold reserves in dollars also reflects trust in our laws and confidence that the US government will not default on any of its debt obligations. It’s hard to overstate the value and importance of such confidence. Perhaps the largest benefit resulting from the dollar’s status as reserve currency is that it keeps the US government’s borrowing costs very low. Think about it. If every country in the world wants to hold a certain percentage of its reserves in your currency, you have a big source of ready demand for your debt and therefore a very cheap source of borrowing. The US Treasury has benefited enormously from these low borrowing costs for the past several decades. It should be noted, though, that large Treasury bond holdings at foreign central banks could potentially be used as leverage in dealings with the US government. Back in 2018 the Russian government sold most of its US Treasury bond holdings, presumably an expression of dissatisfaction with US policies. China has, at various times, threatened to do the same (although not overtly).

A strengthening currency has benefits and drawbacks. On the positive side, a strong dollar benefits US citizens who travel abroad. If you decided to book a vacation to Paris for next summer and the dollar strengthens 10% against the Euro by your departure date, you suddenly have 10% more purchasing power when you arrive. Perhaps more importantly, though, a rising dollar benefits US consumers at home as goods and services imported from other countries suddenly are less expensive. Cheap foreign imports, made possible by globalization and a strong dollar, have provided the US middle class with the ability to buy things that may have busted the budget in bygone eras. However, it should also be remembered that globalization has eliminated a lot of well-paying US manufacturing jobs as well.

But there are also drawbacks to a strong currency. The US dollar’s strength over the past several years has made it more difficult for US multinational companies to compete in international markets. The reason for this is that the revenues generated overseas by US multinational corporations in exchange for goods or services must be converted back into dollars. If the dollar is strengthening, that reduces the number of dollars received upon conversion, allowing foreign competitors to undercut prices for the same goods and services. On a macro level, the intensified global competition resulting from a strong dollar generally will suppress net exports, which is one of the four components of Gross Domestic Product. In addition, because a strengthening dollar leads to lower import prices, the Fed’s Herculean efforts to stoke higher inflation (to its target of about 2%) over the past decade have been stifled by the dollar’s strength. Had the dollar been weakening or even stable during the post-GFC years, it might have been much easier for the Fed to do its job.

So, it should have been no surprise that in the initial stages of the COVID pandemic, there was a knee-jerk reaction to seek the relative safety of US dollars and dollar-denominated assets as a safe haven from the economic carnage. Investors knew that the epidemic would cause a big hit to the global economy, and so there was a “shoot first” mentality that benefited the greenback. However, that initial reaction proved to be fairly short-lived. Since about the middle of May, the dollar has been in decline. My supposition is that with light at the end of the tunnel with regard to COVID, money has been flowing out of the US and into countries and investment opportunities that might offer better upside as vaccines are distributed and the global economy opens back up. As dollars get converted to foreign currencies, the dollar declines in value relative to those currencies. Time will tell whether a collective vote of confidence in the global economy was indeed a wise course of action.

The dollar’s reversal of fortune is good news for some. US multinational corporations can now compete more effectively in the international marketplace. Net exports should pick up, leading to better domestic economic growth. Commodity prices have rebounded quite materially, which is a blessing for struggling companies operating in the energy and materials sectors. Higher import prices resulting from the dollar’s decline may make it easier for the Fed to hit its inflation targets earlier than expected. In short, the global “reflation” that is represented by a drop in the value of the dollar is mostly a positive sign of things to come. Whether or not the financial markets have gotten ahead of the global economic rebound, though, remains an open question.

From an equity investment perspective, the key to navigating currency fluctuations is balance. It makes most sense to hold a good mix of both US multinational companies and more domestically focused domestic companies. Making a currency bet by heavily overweighting large-cap multinationals and underweighting smaller-cap companies, which generate the lion’s share of their revenues domestically, could expose you to a reversal of the dollar’s recent weakness. On the other hand, going all in on small-cap or retail stocks, for instance, could be painful if the dollar continues to decline. Given the inherent unpredictability of currency fluctuations, it never makes sense to be too aggressive.