What you need to know about the rising greenback
10 min read
The dollar has been strengthening dramatically over the course of this year when the Federal Reserve started hiking interest rate hikes in a bid to bring down the skyrocketing inflation. The US Dollar Index, measuring the dollar against a basket of other currencies, is up nearly 17% so far this year, and that’s a significant rise, impacting almost every securities transaction and payment on a global scale.
The USD is strengthening as a result of the Fed’s hawkish monetary policy response to the soaring inflation. At the September FOMC meeting, it raised the federal funds rate from near zero at the start of 2022 to a range of 3% to 3.25%. In fact, many do expect at least another percentage point increase by the end of the year. So exactly how do interest rates affect the strength of a currency?
What exactly is the Fed Funds Rate?
First, let’s gain an understanding of the different types of interest rates involved. The interest rate that the Fed’s contractionary monetary policy is currently increasing is the federal funds rate. This is the rate commercial banks in the US charge each other for lending their excess reserves or cash. Some banks will have excess cash, while others have more short-term liquidity needs, and are thus unable to fulfill the Fed’s reserve requirements. That’s when these banks have to borrow funds overnight. The fed funds rate is the target rate set by the Fed and is usually the basis for the rate that commercial banks lend to each other.
Even though at first look, it seems like this federal funds rate has no relation to consumers like you and me, this rate actually has a far more sweeping impact on the economy as a whole. The fed funds rate is a major tenet of interest rate markets and is used to determine the prime rate, which is the interest rate that banks charge their customers for loans. Changes in the fed fund rate also affect the mortgage and loan rates, as well as the savings deposit rates. This cascading effect is what makes the Fed’s rate hike such big news for the world.
The Fed adjusts interest rates through the Federal Open Market Committee (FOMC) based on the needs of the economy. If the FOMC believes the economy is growing too quickly and that inflation or rising prices are likely, it will raise the fed funds rate. And this is what has been happening throughout the year. Higher rates tend to slow lending and the economy, hence helping to combat inflation.
How does all this affect the strength of the dollar?
Interest rates, inflation and exchange rates are all related. An increase in interest rates means that lenders in the economy have higher returns relative to other countries and this attracts foreign capital. When interest rates across the broad fixed-income securities market increase, it results in higher yields, hence becoming more attractive to investors, both domestic and abroad. Furthermore, the US Treasury market is one of the largest and most liquid markets in the world, with strong legal protection, where investors are confident that they can access their money at any time. Investors around the world are thus more likely to sell investments denominated in their own currency in exchange for these USD-denominated fixed-income securities. Buying dollars pushes up the value of the greenback since its demand increases, and selling other currencies weaken their values.
There are other factors affecting the strength of the USD. While time and again it seems like the US might be going into recession, it’s still looking better than other developed economies like the United Kingdom, European nations and Japan. European economies are currently suffering as a result of the Russia-Ukraine war, especially with significantly higher energy costs. Japan is also grappling with lower global demand for manufactured goods, which make up the bulk of its exports. Even China is facing economic problems with its zero-Covid policy and real estate mess. All these factors, as well as geopolitical risks, are driving investors to safe-haven investments, and the greenback is simply one of the safest bets around at present.
Interest rates differentials also reflect this relative economic strength, adding to the dollar’s appeal. Due to the Fed’s aggressive pace of rate hikes, yields on the US Treasuries are significantly higher than in most G-7 countries, aside from a few commodity-producing nations. If the Fed does follow through on further rate hikes as expected, the short-term interest rate differentials are likely to widen further as US yields rise more rapidly than yields in other countries. It looks like we may expect the strengthening of the greenback to continue at least in the short run.
What are the implications?
A strong dollar helps to keep domestic inflation under control by lowering the costs of imported goods. As the value for the dollar rises, it buys more goods and services. Because the US is a net importer, a 14% increase in the dollar can have a measurable impact on inflation. According to a Federal Reserve Bank of Cleveland study, a 1% rise in the dollar typically lowers non-petroleum import prices by 0.3% over a six-month period. A portion of that drop is reflected in lower overall inflation. It’s certainly not surprising that neither the Treasury nor the Fed has expressed any concerns about the dollar’s recent sharp rise. US citizens are also enjoying their higher purchasing power as tourists when travelling abroad. For the first time in two decades, the dollar and the euro have achieved “parity”, whereby one dollar is worth close to one euro.
However, the rising dollar appears to be more of a bane for many out there than a boon. US companies that sell abroad are seeing their profits getting squeezed. Exporters would be facing the inevitable fall in revenue with the strengthening of the greenback. McDonald’s revenue fell 3% year on year during the summer. However, if the dollar’s value had simply remained constant against other currencies, the company’s revenue would have increased by 3%. Microsoft reported that the changes in foreign currency values also reduced its revenue, and by a whopping $595 million in the most recent quarter. A number of other companies have recently issued similar warnings, and future dollar gains would only serve to put additional pressure on profits. According to FactSet, companies in the S&P 500 index generate approximately 40% of their revenue outside the US.
The combination of a rising dollar and high US interest rates also makes it difficult for investors to maintain a globally diversified bond portfolio. The Bloomberg Global Aggregate ex US Index yield-to-worst is only 1.84% with a duration of 7.6, compared to 3.42% for the US Aggregate Bond Index (Agg) with a duration of 6.3. When the 14% increase in dollar and the yield differential are taken into account, the broad international index has dropped 18% over the past year.
Fed tightening cycles are also particularly harmful to emerging-market (EM) countries. This has been one of the most destructive cycles. Many EM countries and corporations issued dollar-denominated debt in recent years, when borrowing costs were low during quantitative easing and investors were eager to take a risk in order to earn a higher yield. Today, the same issuers may struggle to service that debt with a weaker currency and higher interest rates, resulting in downgrades or defaults.
Furthermore, investors who borrowed in USD to invest in higher-yielding EM currencies, known as the “carry trade”, have suffered significant losses. A negative cycle has emerged in which capital outflows cause EM currencies to plummet, prompting central banks to raise interest rates to halt the outflows, resulting in slower growth. Not surprisingly, EM bonds, both in USD and in local currency, have produced sharp negative returns in the fixed income market over the past year.
The consequences of the quantitative easing that lasted longer than it should have are finally surfacing. The World Bank estimates that close to 60% of low-income debtors are at risk of debt distress, or are already in the midst of it. Many of them had availed themselves to market-based finance, including borrowing at variable interest rates. By 2020, more than 30% of their debt was on a variable interest rate basis, which is attractive when the rates are low, but present a far greater risk in an environment like today, where rates are rapidly rising.
Given the precarity low-income countries, it isn’t all that hard for us to imagine that 2022 has the makings of a comprehensive debt crisis like that in the 1980s. We are talking about economic and financial hardships that are already afflicting tens of millions of people and will only increase significantly in time. Several debtor countries may find themselves navigating choppy economic waters amidst the possibilities of debt restructuring and sovereign default.
Is the world really in a bad place?
All in all, it does appear that we will avoid a systemic crisis of the dollar-based global financial system. The acute pain is largely confined to the weakest and poorest economies, where local resources are scant and dependence on the dollar is greatest. The dollar system might not be considered inherently stable or shockproof, but it has undeniably evolved since the 1990s to manage such stresses, and the more important elements of the network have become far better at protecting themselves.
Of course, how acute the pressure is also very much depends on how dollar and local currency liabilities and assets are balanced. It also helps that many economies are no longer excessively reliant on the dollar, at least not anymore. In addition, the dollar system is deeply entrenched and strengthened by both commercial and geopolitical interests today, and this is an important factor that would help de-risk the dollar-centered global finance in the background.
In general, how severe the tension in the global economy becomes over the coming months will largely depend on how far the Fed’s tightening continues, which in turn depends on how quickly inflation in the US comes down. If it continues remaining high, we can expect the Fed’s hawkish stance to persist, redoubling the squeeze and possibly further strengthening the greenback. On the flip side, if we manage to have a soft-landing scenario where we experience a mild US recession with inflation coming down rapidly, the Fed might be able to ease off the further interest rate hikes for subsequent periods.
A Trader’s View
The Dollar Index(DXY) is a measure of the value of the US dollar against a basket of foreign currencies like the Euro, British Pound, Japanese Yen, Canadian dollar, Swiss Franc and Swedish Krona. It has been strengthening for the past year due to the Fed’s hawkish sentiments and expectations of aggressive rate hikes to cool down the economy. Fundamentally, we should be expecting the USD to be strong for the next few weeks from a short term retracement last week due to the fact that the USD is a safe haven amid global uncertainties and expectations of more rate hikes.
We shall explore the technical aspect of the Dollar Index (DXY).
DXY Daily Chart
As we can see from the above daily chart for DXY, it is currently trading at around 111.70. The 100 Daily Moving Average (in black) is below the 50 Daily Moving Average(in blue), which signifies an uptrend. Using Fibonacci Retracement, from the recent swing low to high, there is a retracement to 38.2% at around 110.31 before bouncing up, which could act as a good support zone. In addition, we can see from the bottom of the chart that the stochastic indicator shows a crossover at an oversold level, which indicates a buy signal. If the daily moving averages, which act as a support zone, hold, we could possibly see DXY hit the recent high of 114.72 and a possible extension to 119.13 if it breaks the recent high.
