US Dollar: What’s All the Fuss?
Following a sharp 10% rise in the value of the U.S. dollar earlier in the year, most dramatically during the stock market meltdown in Q1, the dollar has sold off by nearly -10% since. This pattern is not abnormal during periods of uncertainty, and reflects dynamics on both sides of the equation (it’s important to remember that currency movements occur in both directions).
Since achieving global dominance as the world’s primary reserve currency earlier in the 20th century, replacing the British pound, the dollar serves as the primary pricing and settlement vehicle in world trade. It also serves as a ‘safe haven’ when money flows are moving away from riskier regions and assets. For example, when foreign investors desire to purchase U.S. treasuries, they must convert currencies to dollars to do so. The perceived stability and frequent outperformance of treasuries and selected other dollar-denominated assets during times of crisis has perpetuated this tendency. The safe haven status and global dominance of the dollar have been questioned many times during the years, as a unified Europe and rising China have been proposed as possible alternatives for a global reserve currency, but, for a variety of reasons, this has not occurred.
The opposite condition exists when a crisis abates and investors again seek risk in other asset classes—like European or Japanese equities, for example, if prospects for returns in those regions improves. Then, investors must sell dollars and buy euros and yen. The accompanying pressure would force down the value of the U.S. dollar and cause euros/yen to appreciate. Again, a two way street. In this case, the pursuit of non-dollar assets is the catalyst for the drop in the dollar’s value as opposed to the outright rejection of U.S. assets (which remain highly desirable at last check).
There are other factors that can operate in the background and affect a currency’s value. Certainty, the extreme levels of fiscal and monetary stimulus in the U.S. have generated questions about annual deficits, future higher debt levels, and conditions for higher inflation in years to come. Economists continue to debate these possibilities, but the consensus thinking is that policymakers had no choice, given the highly unusual economic growth drop-off due to the pandemic. In fact, other developed regions (including Europe and Asia) have been sharply stimulating as well, which offsets this dollar-specific negative impact somewhat. Another key factor in currency valuation is real interest rates, which have certainly fallen in the U.S., but remain in line or above rates in other developed nations.
Currency exchange rates normally fluctuate, as much as or more than other financial assets we’re accustomed to seeing volatile movements in. While a ‘strong’ dollar is viewed as a source of national pride and desired in some respects, long-term stability and liquidity are much more important. (The current level of the dollar index is about where it was five years ago, for comparison’s sake.) In fact, a weaker dollar can be a benefit for manufacturing exports, and is seen as a stronger tool for domestic economic stimulus than an overly strong dollar.