Is the US dollar invincible, or just the best house in a bad neighbourhood?
- Dollar strength has been a wrecking ball swinging through forex markets, buoyed by the Federal Reserve’s interest rate increases and severe problems facing other major economies
- If the Fed were forced to cut rates – because the US enters recession or due to a threat to the global economy – the dollar would depreciate
Just a cursory glance at the abysmal performance of leading asset classes this year shows there are few places for investors to hide. Among more than 35 assets across developed and developing markets tracked by JPMorgan, only two major ones have delivered positive returns.
The first is commodities, which have been driven higher by price shocks stemming from Russia’s invasion of Ukraine. It is the second, however, whose rise has been unrelenting and has more momentum behind it.
The US dollar’s rapid ascent has been a wrecking ball swinging through foreign exchange markets. While emerging market currencies have suffered, most of the damage has been in advanced economies.
The damage extends far beyond currency markets. Many countries and companies, especially in the developing world, borrow in dollars. When the US’ currency strengthens sharply, the cost of servicing dollar-denominated debt from revenues in local currency increases, resulting in a liquidity squeeze.
Yet, the underlying cause of the dollar’s strength is the more severe problems facing other major economies. To put it simply, the dollar is the best house in a bad neighbourhood.
The dollar is also benefiting from its role as a sanctuary in times of uncertainty. Investors seek refuge in the world’s dominant reserve currency even when the US itself is the source of the turmoil. This shows the extent to which the depth, liquidity and relative safety of US markets outweigh political and economic risks in the country.
Still, the dollar is not a one-way bet. If the Fed were forced to cut rates – either because the US enters recession or because of a systemic threat to the global economy – the greenback would depreciate. Even signs that the Fed is turning dovish would weigh on the US’ currency.
For the time being, however, the dollar is, in the words of veteran bond investor Bill Gross, the “cleanest dirty shirt”. Given the Fed’s determination to rein in inflation at the cost of inducing a recession, the shirt in question is bound to get dirtier.
Nicholas Spiro is a partner at Lauressa Advisory