Why is the dollar so strong?

By:
on Jul 18, 2022
  • US Dollar hit parity with the euro for the first time in 20 years last week
  • History has seen this pattern of dollar strength time and again in previous recessionary periods
  • Economic uncertainty, an aggressive Fed and rising energy prices all contributing

The dollar’s dominance in the forex markets continues, as last week we witnessed the significant milestone of $1 trading for €1. With the rate being $1.20 only a year ago, it’s a staggering march by the dollar – but why are we seeing this trend? And while it has slowed a little in the last few days, will its strength continue or could there be a reversal?

Dollar strengthens in times of uncertainty

The dollar is the world’s reserve currency, one side of most foreign exchange transactions – as high as 90% by some estimates. As the largest, it is also perceived as the most stable and safest currency in the world. In times of uncertainty, investors flock to safety, and hence the dollar has risen historically. I plotted the DXY Index, which measures the strength of the dollar index against a basket of foreign currencies, against recessionary periods since 1970 and the results can be seen pretty clearly – it rises during times of turmoil.

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To hit this uncertainty point home, we can hone in the March-2020 period when COVID concerns really ramped up.

To refresh your memory, four of the sixteen biggest daily moves in the history of the S&P 500 came in March 2020. I vividly recall being suddenly sent home from the office, as our Prime Minister (Leo Varadkar – I lived in Ireland at the time) made an emergency announcement that all schools and offices would shut.

It feels like a million years ago now, but the market was in mayhem as it was clear that this surreal virus was more than just an isolated incident in China.

And the dollar index? It strengthened 8% in only ten days – a momentous move for a currency in such a short time period.

Why does the Fed raising rates strengthen the dollar?

But there are other factors here aside from recessionary fears. The Federal Reserve has been more aggressive than foreign banks in raising interest rates to combat the spiralling inflation we are witnessing.

The 75bps rate rise in June was the largest since 1994, while the next hike could be 100bps (although expectations have moved towards another 75bps hike). As a general rule, a higher interest rate will attract capital from abroad, as investors seek to earn the extra yield available on bonds and other interest-earning products.

More capital flowing into the US -> more dollars bought -> dollar appreciates.

Rising energy prices

The other major dial-mover here is energy pricing. You don’t need me to tell you that the price of energy has rocketed this year. The US imports less oil than many other countries – again, my trusty Europe struggles here – meaning it spends less money on energy imports and therefore isn’t as badly affected as many other currencies.

Conclusion

The above factors are the main ones. The uncertainty sees no sign of abating anytime soon, as sentiment is still bearish and fear high. While the Fed remains ahead of other central banks in hiking rates, it therefore doesn’t feel like this dollar strength will reverse anytime soon. Of course, this is all speculation and the energy pricing is still a wildcard (who knows what happens in Ukraine) and may affect things, however on an overall basis there is nothing to suggest an abrupt curtailment of the dollar’s strength.

And hey, say a prayer for me – I’m an Irish (euro) kid writing this from Miami. It will be peanut butter sandwiches for breakfast, lunch and dinner for me if this continues much longer…

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