The Surging Dollar and Predictions for the Future
Financial news is full of stories about the strong dollar. The high-priced greenback is affecting virtually every industry in every country around the globe. Companies are blaming earnings shortfalls on “currency headwinds,” and emerging economies are struggling with the increased costs of dollar-denominated debt.
Why the Dollar Has Risen and the Likely Outcomes
There are a few reasons why the dollar has risen in strength over the last 16 months. The U.S. economy emerged from the pandemic in better shape than most countries. Additionally, rising inflation, brought on by supply chain issues, pushed the Federal Reserve (U.S. central bank) to raise interest rates, increasing yields to global investors holding dollars.
The U.S. is less vulnerable to the adverse effects of higher global oil prices, and war and uncertainty across the globe have given the dollar “safe haven” status. These factors have led to the dollar becoming the “reserve currency” of the world.
The strong dollar has led to global increases of the costs of commodities priced in dollars (oil, natural gas, metals, food) and the servicing of dollar-denominated debt for emerging economies. Those economies are being hit hard by the double whammy of a higher dollar and even higher interest rates. This has led to a reduction of direct investment in emerging markets as investors fear currency depreciation. And finally, the strong dollar has increased the cost of goods exported from the U.S.
What Could Cause the Dollar to Reverse Course?
There are three factors that could cause the rise of the dollar to stop.
- The dollar becomes overvalued, and market forces cause a drop.
- Major central banks initiate actions to reverse the dollar’s course against their currencies.
- Other currencies overtake the dollar’s role as the world’s reserve currency.
Let’s take a closer look at some common questions that come from examining all these possible outcomes.
Is the dollar overvalued?
By many measures, yes. In terms of purchasing power parity (a comparison of how much currency it takes to buy equivalent goods in various countries), the dollar is now 14% overvalued against the British pound, 7.5% overvalued against the euro, 31% overvalued against the Chinese yuan, and a whopping 45% overvalued against the Japanese yen.
If the dollar is overvalued, does that mean a drop is imminent?
The short answer is no. The forces driving the higher dollar (interest rate advantage, energy independence, reserve currency status) are not likely to change in the short term. History suggests that the dollar may become more overvalued before changing direction.
Will central banks step in to stop the dollar appreciation?
This is possible, but it will require agreement among many countries to take concerted action. At this point, there is no political will to take this type of action. The last time we saw this type of agreement was in 1985 (Plaza Accord).
What is the likelihood of other currencies assuming the role of reserve currency?
Economists have suggested that the dollar’s reserve currency status will ultimately be taken over by or shared by other currencies, primarily the yuan or the euro, because no reserve currency has ever permanently maintained its hold. However, because of complex geo-political issues, this take-over is unlikely to occur any time soon and would more likely occur over a longer period of time unless the U.S. experienced a highly-isolated political or economic disaster.
My company has exposure to FX risk. What should we do?
No one can predict when the dollar will change course. However, we can assume that the current trend will persist until conditions change. Companies should continue to hedge against dollar appreciation. But the problem with that approach is that hedging is complex, and most companies need more tools and expertise to implement an effective hedging program.
This is where hedging tools, like the kind offered by Pangea, can be beneficial. Keep in mind that at some point, the dollar will drop. If history is a guide, the drop in the dollar may ultimately prove to be at least as challenging to balance sheets as the rise we are currently experiencing.
Takeaways
- Dollar momentum is the story now. Expect the trend to persist in the short term.
- A strong dollar may lead to a global crisis, prompting concerted action by central banks, and some economists are saying we are already in a crisis.
- At some point, the dollar will reverse, but volatility will most likely continue, meaning a high degree of risk in FX.
