Why is the Dollar So Strong?
Why is the Dollar So Strong?
What led to the dollar's rise in 2022 and will it last?
The United States dollar is the world's most widely used currency. It’s a benchmark for the pricing of goods and services in many countries, a key player in international trade, and the world’s global reserve currency. But why is the dollar currently so strong, and will it weaken soon?
The Effects of a Strong Dollar
“A strong dollar” sounds like a positive phrase for anyone who conducts business using them. However, as we’ll see below, this isn’t necessarily the case.
The Negatives
Although a strong dollar may be good for US consumers and importers, it can actually have a serious negative impact on businesses that export goods in dollars; it makes dollar-priced goods less competitive on the international market.
One of the best examples of this in recent years is Apple’s price increases on iPhones sold overseas. Earlier this year in Japan, Apple increased the price of the iPhone 13 from 98,800 yen ($730) to 117,800 yen ($900), a rise of nearly 20%. In the UK and Germany, the price rose by around 10%.
The increase makes iPhones more expensive than other brands in international markets and makes Apple’s growth much harder overseas. Luca Maestri, Apple’s Chief Financial Officer, said “With respect to foreign exchange, we expect it to be a nearly [3%] headwind to our year-over-year growth rate" - a significant amount when Apple's total revenue growth in 2022 vs 2021 is expected to be just 8%.
Microsoft also cut its revenue and profit outlook in the second half of 2022, citing currency fluctuations as the main reason.
This is part of why US stocks performed so poorly in 2022. A strong dollar hurts their overseas sales and dents their earnings. Given that about 58% of US tech company revenue comes from overseas, it’s easy to see why 2022 has been so bad for the NASDAQ.
A strong dollar can also harm commodities and the developing markets that need them to bolster their manufacturing industries. Commodities worldwide are priced in dollars, so the stronger the dollar, the more expensive a commodity is for those using other currencies to buy them. This generally lowers the demand for the commodity and drives down its price.
The Positives
The positive side of a strong dollar means that businesses in the US can import more product per dollar. If you’re a company in the US importing clothes from Asia, a strong dollar is probably extremely helpful.
Through this mechanism (in theory at least), a strong dollar also helps drive down US inflation; it makes imports cheaper and lowers the supply of dollars going out into the global economy.
Where most US citizens appreciate a strong dollar though, is when it comes to going abroad. Those traveling and spending in dollars will notice they can buy much more for less in dollar terms when the dollar is stronger.
Its Role as a safe haven
The dollar is widely seen as a “safe haven” - meaning people want more of it in times of turmoil and less of their domestic currency. It’s backed by the US, which controls the world's largest economy and most sophisticated military.
The US also controls the world’s largest gold reserves (mainly thanks to the Bretton Woods Agreement of 1944, which made gold the basis for the dollar). Unlike other countries which use U.S. dollar securities, in the form of US treasuries, instead of gold to keep their reserves safe. Dollar securities are considered a reliable store of money, making the dollar a desirable "safe haven" currency during uncertain times.
Many economies also faced domestic issues in 2022. Turkey rather weirdly cut interest rates throughout the year despite their already weak currency and inflation being at ~80%. The president, Recep Tayyip Erdogan, has the unorthodox belief that raising interest rates increases inflation. The exact opposite of what most economists believe.
The UK unveiled a “mini-budget” on the 23rd September. The budget outlined the government's plans to cut taxes for the rich despite the coming winter hardship and higher energy prices for all. The news sank the pound to $1.033 - its lowest ever level against the dollar. Soon after the announcement, the Bank of England stepped in and began buying pounds to push the price back up. Thankfully, the government backtracked on this plan, and Liz Truss, the Prime Minister, resigned after just 7 weeks.
Given the uncertainty in the world in 2022, it’s easy to see why many investors flocked to buy dollars. But there was another key reason the dollar rose during the year - rising interest rates.
Interest Rates and Inflation
Throughout 2022 the Federal Reserve has been raising interest rates to bring down inflation. Higher interest rates mean people borrow and spend less, slowing the economy down and slowing the rate at which businesses raise prices. This means less money is in the system, which leads to lower inflation.
The increase in interest rates was arguably the most significant factor in the dollar’s rise in 2022; they were historically low in the US from 2010 - 2020.
The increases through 2022 meant that by December 31st, the interest rate was 4.5%, significantly higher than at any point from 2010 - 2020.
The Fed’s ultimate goal is to get the level of inflation down to the US (and most other) government’s target level of 2%. If inflation is too high, as it is now, it’s hard for businesses to set prices and for people to plan their spending. If it’s too low or negative, people will be hesitant to spend, knowing they can wait to buy the good at a lower price in the future.
It’s looking like the Fed will begin to slow its interest rate increases early this year and may even cut them slowly towards the end of the year. If it does, we may well see the dollar come back down and closer to its historic norms.
Outlook for 2023
2022 has given us two things we haven’t seen for years - increasing interest rates and war. Both have contributed significantly to the rise in the value of the dollar this year. It’s unlikely we’ll see the same strength through 2023 in my opinion, despite its strong start to the year.
US interest rates won’t grow as quickly and could even fall toward the end of the year. I think the Russia/Ukraine conflict will also die down, and the outcome will favor Ukraine, although how Putin will react to that is anyone's guess.
The factors that pushed the dollar up in 2022 just aren’t there anymore, and many are beginning to unwind. The decline won’t be steady, and I don’t think it will be as far as some are predicting, but I think it’s a fairly safe bet that the dollar will be lower at the end of 2023 than it is now.