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T Dollar - Rise

The Fed is tightening monetary policy more aggressively than other major central banks. And U.S. growth prospects, while weakening, look better than those of most other major economies. Small wonder the dollar has strengthened sharply across the board.

T Dollar - Rise


The U.S. is hardly an island. What happens in the rest of the world affects its economy and the Fed accounts for that in its policy making. But should the Fed explicitly consider the direct effects of a stronger dollar or high U.S. interest rates on other countries when setting rates?

A world without a single dominant currency would not necessarily be an improvement. Foreign investors need abundant safe assets in a trusted currency that they can invest in and sell easily when needed. In the absence of one, they would be far more likely to panic when troubles arise. Without a credible central bank that can engineer massive infusions of money to meet worldwide demand at critical times, bad situations might become worse.

Rather than complaining, other countries should reduce their reliance on the dollar and earn the trust of foreign investors by adopting better policies and improving their institutions. For now, they should cheer the Fed on for doing what is necessary to rein in inflation and avoid even more tightening and global economic pain down the road.

But the US dollar index retreated somewhat earlier this week, as investors grew increasingly hopeful the central bank will pivot away from its aggressive monetary tightening. Those hopes were fueled by a fall in US job openings and a lower-than-expected rate increase in Australia.

The impact of Russia's ongoing war on Ukraine on Europe's economies is likely to prop up the dollar while weighing on the euro, according to UBS. The eurozone currency has slumped 12.4% to dip in and out of parity against the buck this year, and it was trading at $0.9898 at last check Thursday.

With little to move on after the Federal Reserve announced it would leave U.S. overnight interest rates unchanged on Wednesday, the dollar remained near its highest level of the year. In just the last few weeks it has taken back lost gains against world currencies like the euro, British pound, Japanese yen and other global stalwarts.

As the U.S. rates moved higher, with other major central banks (including the Bank of England) at a standstill, the dollar only trudged lower, falling by around 10% in value last year. That trend had continued in the early months of 2018, but then reversed sharply.

Much of the short bets against the dollar have been driven by an expectation that the European Central Bank will begin paring back its massive stimulus program that is injecting more than $30 billion into the economy each month sometime this year and that the Bank of Japan is likely not far behind.

We also look at an exchange-traded fund whose value is directly linked to the dollar by tracking the U.S. Dollar Index (USDX), which measures the value of the greenback versus a basket of six key foreign currencies.

With the U.S. economic outlook for 2023 uncertain, the path forward for the U.S. dollar could have significant implications for inflation, international trade, technology stocks and fiat currency alternatives such as gold and Bitcoin (BTC).

There are a number of reasons the dollar gains strength in the market. In the past year, the Fed has raised interest rates eight times to a current target range of between 4.5% and 4.75% in an aggressive attempt to curb inflation. The higher interest rates rise, the more demand for the dollar there is from international investors seeking yield.

Also, investors sitting on the sidelines and waiting for a better time to buy stocks can currently earn an interest rate of 4% or higher on the dollar in top high-yield savings accounts. These accounts are essentially risk-free for balances of up to $250,000 per bank, as long as the bank is insured by the Federal Deposit Insurance Corporation (FDIC).

A strong dollar can be bad news for U.S. companies that do business overseas. If the value of the U.S. dollar is high, companies lose revenue when they convert international sales into U.S. dollars. Roughly 40% of S&P 500 revenues are generated outside the U.S.

The dollar also has a negative historical correlation to fiat currency alternatives, such as gold and Bitcoin. While the U.S. dollar has rallied in the past year, the prices of Bitcoin and gold have fallen.

The good news for investors is a strong dollar can continue to benefit certain stocks that generate limited international revenue. Bank of America recently screened for S&P 500 stocks that have historically had the most positive correlation to the strength of the dollar over the past decade.

Investors willing to take on more risk for more potential upside can also directly buy U.S. dollar futures or options contracts. Any investor trading these types of derivatives should understand how they work and the risks involved.

In some cases, the issuers of these currencies also have bilateral swap lines with the Federal Reserve. This, it can be argued, creates confidence that their currencies will hold their value against the dollar.

The value of the US dollar has risen sharply this year compared to currencies of many other countries including the British pound, the Japanese yen, and the euro. The dollar is at its highest level in 20 years against other major currencies while the pound is at its lowest level against the dollar since 1985, the yen is at its lowest point since 1998, and the euro is worth less than the dollar for the first time since 2002."

A stronger dollar sounds like a good thing, like seeing results from all those hours you've spent in the gym. However, currency markets are not weightlifting and being strong is not without negative consequences if you're the dollar. In fact, it may be possible that the dollar has now become too strong for its own good.

To understand why the dollar's strength may not be an unquestionably good thing, it helps to understand how currencies are valued. The amount of a country's currency that can be bought with a specific amount of another country's currency is always in flux. Even countries with close economic and geographic ties such as Canada and the US can see wide swings over time in how much a US dollar buys in Banff or what a Canadian dollar is worth in Key West. Those fluctuating currency values reflect how much the governments, companies, banks, and individual investors who buy and sell in global currency markets are willing to pay. Their views on the relative values of currencies mostly reflect where they believe they will get the best return on their investment.

Typically, if a country has relatively strong economic growth and low debt, its currency will be sought after in global markets which will cause its price to rise. On the other hand, countries whose growth is weak and debt is high may see less demand for their currencies and their value will lag those of countries with more robust economies.

Many investors see the dollar as the safest asset to hold when stock and bond markets turn volatile as they have this year. That's partly because the dollar has a unique status as the world's "reserve currency." This means central banks and financial institutions around the world hold lots of dollars to use for international transactions. They do this because using a single currency rather than having to convert between currencies helps enable international investing and lending.

The dollar has also gained strength because the US economy looks healthier than those of many other countries where growth is slower and debt and inflation higher than in the US. Europe in particular is struggling with high inflation and slowing growth due to energy supply disruptions resulting from the war in Ukraine and may already have entered a recession.

The dollar's strength also reflects the markets' views on the policies of various countries' governments and central banks. The Federal Reserve is focused on slowing inflation and is raising interest rates higher and faster than are central banks elsewhere. Meanwhile, the UK, which is struggling with both high inflation and weak growth, has announced a package of tax cuts which has helped push the value of the pound against the dollar to its lowest point in decades.

The most obvious risk a strong dollar poses is the way it can hurt the US stocks that many people rely on as mainstays of their retirement accounts. The US-based companies that make up the S&P 500 earn nearly 40% of their revenues outside the US. As Fidelity Director of Global Macro Jurrien Timmer explains, "When the dollar rises against, say, the euro, as it has done in the last year, then a company's euro-denominated sales are worth less once they're exchanged into dollars." That means a rising dollar is likely to have a noticeable impact on these companies' revenues, earnings, and stock prices.

Besides hurting earnings, a super-strong dollar can also hurt prices of US stocks and bonds by making them more expensive for big non-US institutional investors. Faced with higher prices, they may opt to invest their money elsewhere, dragging US markets downward in the process.

While a strong dollar may hurt US stocks, it also makes international stocks a bargain for US investors who want to diversify their portfolios. Historically, international stocks have outperformed US stocks and they also have tended not to rise or fall in lockstep with US markets. Over time, diversifying with non-US stocks may reduce risk in an investor's portfolio. The strong dollar may also help the stocks of non-US companies who operate in currencies such as the yen or euro but who export their products to the US.

However, Fidelity Director of Quantitative Market Strategy Denise Chisholm warns against making major changes to your investments based on fluctuations in foreign exchange rates. "The strength of the dollar hasn't historically been much of a predictor of how stock sectors will perform. If you bought or sold sectors based on the typical historical outcomes when the dollar has appreciated by 10% or more in a year, which is the situation we're in, you'd have made the wrong move for 7 of the 11 sectors," she says. 041b061a72


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