Why Is The U.S. Dollar So Strong And Where Does It Go From Here?

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While 2022 was extremely challenging for the majority of financial markets and assets, the same could not be said for the U.S. dollar, which has been steadily strengthening over recent months against other currencies.

The dollar index (DXY) is up almost 11% since the start of the year after hitting the 20-year high in July. Specifically, the greenback is up 15% against the Japanese yen this year, and up 10% and 5% against the British pound and China’s renminbi, respectively.

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Furthermore, the dollar also reached parity with the euro for the first time in 20 years last month as the European currency faced severe headwinds due to record-high inflation and Russia’s invasion of Ukraine.

Why Is The Dollar So Strong In 2022?

The dollar’s uptrend shouldn’t come as a surprise as currency movements have previously been strongly related to interest rates and economic activity. A great example is the ongoing hawkish monetary policy by the Federal Reserve, which has been hiking interest rates at the strongest pace in 30 years.

“The dollar is strong because the Fed is in the midst of the most aggressive monetary tightening policy among major central banks in the world,” said Eric Leve, CIO at investment manager Bailard.

Leve explained that interest rate hikes have pushed government bond yields into the green for the first time in several years, making U.S. bonds significantly more appealing for global investors and thus adding to the dollar’s value.

He also said that the Fed’s aggressive rate hikes have made the U.S. economy better positioned than other major economies in terms of inflation and recession risks.

Because of this, the U.S. economy is “in many ways the cleanest dirty shirt,” said Leve, and is much more appealing to global investors who are concerned about mounting consumer prices.

Is A Strong Dollar Good Or Bad?

The strengthening of the dollar suggests that Americans can now travel at a discount and more importantly, its gains can help reduce the devastating impact of the 4-decade-high inflation in the United States.

However, not everyone is pleased with the dollar’s progress. A stronger dollar has been leaving an adverse impact on some countries in the world and has emerged as a major headwind for U.S. companies with strong international operations.

Generally speaking, a stronger U.S. dollar is more of a headwind than a tailwind. For example, some countries that have substantial national debts denominated in US dollars are now facing extreme difficulties paying back their creditors or purchasing the necessary amount of basic goods. This can be seen from the trading activity of most currency pairs on popular forex trading platforms.

This is what happened in Sri Lanka, which defaulted on its debts earlier this year following as its currency weakened.

“Every country that has large liability in dollars is a cause for concern,” said Marcello Estevão, the World Bank’s global director for macroeconomics, trade, and investment.

In addition to weighing on the rest of the world, U.S. companies are also among those that have not welcomed the dollar’s recent gains. The greenback’s uptrend has wiped billions of dollars of the corporate sales in the U.S. in the second quarter, urging a number of companies to slash their outlook for the rest of the year.

Morgan Stanley’s chief U.S. equity strategist Michael Wilson, warned the bank’s clients last month that a “very strong” U.S. dollar will act as another headwind for earnings.

“US companies in aggregate generate ~30% of sales abroad. The rate of change on the dollar exhibits a strong negative correlation over time vs. S&P 500 earnings revisions. USD strength comes at an inopportune time for corporates already facing margin pressure and increasingly weaker demand. 2Q earnings season should be a negative catalyst for equities in the coming weeks,” Wilson told clients.

A number of companies already cited the strong dollar as a reason why they missed the analyst targets, including IBM, Netflix, Philip Morris, and J&J, Apple and Microsoft.

Investors and analysts have been closely monitoring the earnings season, seeking signs of a weakening global economy as raging inflation and hawkish monetary policy affect business and consumer demand. Current economic data is already suggesting a slowdown in economic activity as consumers’ purchasing power weakens.

Once the slowdown is coupled with still red-hot inflation and strong dollar, it’s clear why many analysts see the next leg lower in equities being fueled by earnings estimate cuts.

“Even if the rise of the dollar was to stop here, the strengthening we’ve seen over the past 12 months would be enough to prompt further downgrades to earnings estimates just because of the foreign exchange headwinds,” said Max Kettner, a strategist with HSBC.

Where To Go From Here?

Although the U.S. dollar has appreciated against the majority of currencies this year, the greenback is yet to peak, according to currency strategists. The dollar slipped from a decade high last month but regained ground quickly after the U.S. central bank hiked interest rates at a record-high pace.

Analysts expect the Fed to maintain a tighter monetary policy relative to its peers and a significant slowdown in the global economy is almost inevitable.

While the slowdown could notably weaken the dollar, over 70% of strategists in a recent survey said they think the dollar hasn’t peaked yet. A smaller percentage of strategists said they expect the greenback to peak within three months, while 19 of them think it will reach its peak within six months. Only 16 strategists said the dollar has already peaked.

"For the USD to weaken, the Fed has to be more concerned about growth than about inflation, and we are not there yet," said BofA's strategist Michalis Rousakis.

The greenback was expected to lose some of its gains over the following 12 months, while just a few of the major currencies were anticipated to recover from this year’s losses over that period.

UBS analyst Brian Rose said the dollar is likely to substantially weaken in the long run, but he does not expect the greenback to meaningfully decline in the 12-month timeframe.

"In the short term we're looking for the dollar to maintain its strength, especially against the euro. So we think there's a chance the euro will drop below parity," Rose said.

Currency strategists polled by Reuters expect the USD to gain more than 6% from its current levels by July 2023. Moreover, they expect the EUR/USD to trade around $1.02, $1.05, and $1.08 in the next three, six, and twelve months, respectively.

Although only a couple of analysts expected the euro to trade at or below parity versus its U.S. counterpart over the forecast period, around one-third of the surveyed 60+ analysts now expect it to hit those levels again in the following three months.

The dollar received an additional boost this week after fresh economic data in China added to global recession fears and weakened the yuan following an unexpected interest rate cut by China’s central bank.

Chinese industrial production, retail sales, and fixed-asset investment all missed analyst consensus estimates as the country’s stringent zero-COVID policy significantly restrained economic recovery.

Worrying data from China also worsened recession concerns for the rest of the world, which is one of the factors that weakened the euro against the dollar. The currency situation is now impacting cryptocurrency markets as well. Crypto has become easier to use with barriers to entry minimized, thanks to a number of different wallets available for trading cryptocurrencies. Despite increased adoption, cryptos are continuing to experience an impact from the larger macro environment.

Summary

The strong U.S. dollar has intensified headwinds for U.S. cooperation that generated revenue from abroad and could ultimately fuel the next leg lower in the stock market. In the meantime, strategists expect the greenback to stay strong as the Federal Reserve contemplates the third consecutive rate hike of 75bps.

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