Is the US Dollar expected to remain strong for the foreseeable future?

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Overview

The US Dollar (USD) last month challenged the highs seen 20 years ago. While it is a little complex to understand its relative performance versus the entire set of world currencies. In this article the US Dollar Index (DXY) will be used for an easy reference. The index is a basket of six currencies from the developed world (see the chart below and its composition). The DXY around >109 is approximately 74 percent higher than the lows of around 74 seen during 2008 and 2011 — a double bottom, if you will. It is still far from the 120-peak seen in early 2002. And, certainly very far from the all-time high of 152.72 printed on the first day of 1985 (the period of high inflation and high interest rates).

The (USD) has enjoyed the unofficial title of world’s reserve currency for over a century now. The American currency earned the trust of the most part of the global populace and governments on the back of several favorable features. Let us rewind a bit to understand the prime reasons behind the might of the USD.

The American economy grew rapidly between 1870 and 1900 after the Civil War, fueled by an astonishing growth in wealth, production, corporate mergers, and wages against very little government regulations. Corporate America raised investment capital and dove deeply into the development of new technologies. This created a huge growth in the stock market volumes, in turn, giving the USD a very solid backing as demand for the currency grew sharply.

With the rest of the world moving at a snail’s pace, the United States leap-frogged and began developing capital markets with issuance of financial instruments (bonds and CDs etc.) The world started looking at the USD as a safe-haven currency. Although the US sovereign debt issuance saw a never-ending growth for the next hundred years turning Uncle Sam into a net debtor nation, yet the world gave the USD a strong thumbs up. Even when the first ever ratings downgrade of the US Treasury Bonds (UST) from AAA to AA+ by the ratings agency S&P took place on 5 August 2011, not only the UST prices rose, but even the USD took off to never look back (low of 74 in 2011 alluded above). The downgrade was made on the S&P’s premise of the US no longer being the preeminent sovereign power of the world. The very large budget deficits and rising government debt were named as the prime factors behind the downgrade. Then why did the UST yields drop, and the currency shoot up? Simple, because the world considered the other countries (and their currencies) to be even weaker if the mighty US was being downgraded. The funds inflow just ballooned.

DXY — the US Dollar Index

The U.S. Dollar Index tracks the strength of the dollar against a basket of major currencies. DXY was originally developed by the U.S. Federal Reserve in 1973 to provide an external bilateral trade-weighted average value of the U.S. dollar against global currencies. U.S. Dollar Index goes up when the U.S. dollar gains “strength” (value), compared to other currencies. The following six currencies, in the order of weightage, are used to calculate the index: Euro (EUR) 57.6%, Japanese Yen (JPY) 13.6%, Pound Sterling (GBP) 11.9%, Canadian Dollar (CAD) 9.1%, Swedish Krona (SEK) 4.2%, Swiss Franc (CHF) 3.6%.

Are there any alternatives to the USD?

There has been a lot of noise about reducing the dependence on the USD by finding an alternative to the world’s longest-serving reserve currency. Unfortunately, there are hardly any suitable and formidable options. The Japanese Yen is going through a long-term flattish zero interest rate journey and remains heavily dependent on crude oil imports. With Europe falling victim to repeated financial crises, the Euro (a nineteen-country European currency basket) does not have a unified or clear fiscal roadmap and offers zero interest rates versus sub-zero until recently. Besides, most importantly, the biggest bond market for the world to lend money in Europe (the German Bunds) is simply not “deep” enough and therefore, cannot absorb even a small part of the global liquidity. China remains steadfast in its protectionist and authoritarian policies. Her recent incidents of muscle-flexing and over-assertive overtures are not helping the Renminbi either. Japan and China, themselves, hold US treasuries worth USD1.21 trillion and USD980 billion respectively. The UK has its own dose of financial woes. The ill-planned fight against Covid and war-induced-inflation have left much to desire for the once mighty Pound Sterling, which is hovering around par with the USD.

At this moment, it remains an unlikely scenario that the USD will lose its title as the “world’s most trusted currency.” Beyond the major currencies of the United States, Europe, Japan, and the United Kingdom, there is a category of “other currencies” that includes the Canadian and Australian dollars, the Swiss Franc, and the Chinese Renminbi (Yuan). They now hold 10 percent of global reserves, up from 2 percent in 2001.

Digital currencies are trying to make an entry on the global stage, but their significance and agility are still far from fruition.

And there are also BRICS countries, recently joined by South Africa. The countries have been discussing the possibility of creating their own currency to replace the US dollar. The move would mean that the BRICS countries would become one large economy. Such cooperation aims at increasing cooperation in the areas of trade, investment, technology and development. The creation of this new currency would definitely disrupt the current economic order. However, it is unsure as to when and if this happens.

General implications of a strong USD

A strong USD attracts global fortunes to its shores, financial market, banks, businesses, and treasury. The strong US currency makes the rest of the world a competitive exporter due to their respective currencies, conversely, being weak. The gold and oil, quoted in USD, have an inverse relationship. As the USD strengthens, the two asset classes weaken and vice versa. That is the general scenario.

Current scenario

The pandemic-induced economic woes combined with supply-chain restrictions due to the Russia-Ukraine war have created a double whammy for most parts of the world. A strong USD makes world’s imports costlier. Crude oil, food grains and input materials such as semiconductors currently make up the large chunk of the world’s trade deficit. Contrary to general conditions, the crude has stayed strong due to supply-constraints. Any currency-favored exports gains are easily outweighed by the unfavorable currency factor in imports that have run much higher in recent times. To top it all, the inflationary forces have prompted the world (without Japan) to adopt a tightening monetary policy. Ironically, the US, here too, stands to gain as most of the liquidity finds USTs as more attractive alternatives to their European or Japanese counterparts.

Thoughts/Opinion

Technically, the bulls of the USD have been persistent due to the perils of the rival currencies. It is worth noticing, however, the value of the USD versus other major currencies is presently 20 percent above its long-term trend. The USD is also above the peak of 2001 post the dotcom bubble burst when it started its six-year long downtrend. Since the 1970s, the typical bullish trend in the USD has lasted about seven years. The current upswing is in its 11th year, point to note.

Fundamentally, a current account deficit persistently staying above 5 percent of gross domestic product is a reliable signal of an upcoming financial disruption. Although rare, it is mostly true in developed countries, where such incidents are concentrated in crisis-prone peripheral European nations such as Ireland, Portugal, Greece, and Spain. The US current account deficit is now kissing that 5 percent threshold, which it has broken only once since 1960. That was during the dollar’s downswing after 2001.

Additionally, the US currently owes the world a net $18tn, or 73 percent of US GDP, far beyond the 50 per cent threshold that has often left the writing on the wall about past currency crises in the making.

Further, in recent years, the US has been growing significantly faster than the median rate for other developed economies, but the signs of a deceleration are already indicating a reversal of roles against its peers in coming years.

The global recession fears due to poor economic conditions. In many parts of the world, especially the US, inflation seems to be still unpredictable. If the Fed and other major global central banks reach their target to contain the inflation, most probably by the year-end, the rate hike cycle should be over. However, the Fed indicated to be data-dependent before any future rate action. The interest rate differential, currently in favor of Uncle Sam, could dissipate thereby reducing fuel to the USD rally. The non-USD currencies could begin their revival which should reduce their import bills further improving their fiscal balance sheets. Non-USD risk-on trades should return to the center stage.

The fundamental and technical imbalances for the USD seem to indicate a meaningful correction in the USD soon. The million Dollar question is whether it will happen now or after another ten percent upswing to test the overhead resistance around 120, which will certainly push the DXY index further into an overbought territory.

Thank you for reading.

Disclaimer: The information contained in this blog is strictly for educational and entertainment purposes only. This is also not an investment advice. All views expressed in this blog are my own and do not represent the opinions of any entity whatsoever with which I have been, am now, or will be affiliated.