The US dollar can't be stopped. Fueled by the Federal Reserve's aggressive tightening policy, the value of the greenback is appreciating to multi-decade highs and squashing currencies around the world.
Typically, it's emerging-market countries that shoulder the burden of a strong dollar. That's because developing countries have been encouraged by US policymakers, investors and corporations to tie their currencies to the US dollar. The strong dollar crushes poorer countries that must meet their debt obligations in dollars and rely on the US for food imports.
But something strange is happening during this ascent. The dollar is currently appreciating more against the currencies of rich economies than it is against those of emerging markets.
Investors looking for a nice return on government debt often turn to high-risk developing nations because they pay out high interest rates. When the Federal Reserve raises interest rates, investors realize they can get those payouts without the risk and move their money to the US instead. That boosts the dollar but sends the developing market currencies into freefall.
But central banks in emerging countries are also tightening this time around as developed countries keep interest rates relatively low, and so the rules have changed. That, plus heightened fears of war-induced recession in Europe have led investors to pour into the dollar.
Trouble ahead: The Euro is at a 20-year low against the greenback, and the British pound is at its lowest level against the dollar since 1985.
The Fed's trade-weighted dollar index, which measures the value of the USD based on its competitiveness with trading partners, has grown by 10% this year against currencies of other advanced economies, its strongest level since 2002. By comparison, the dollar is up just 3.7% against emerging markets' currencies.
The change is adding to a number of challenges already increasing inflation in Europe as the continent heads into winter with a looming energy crisis. Energy import prices in Japan are also growing, and worsening because of the dollar. The S&P 500's top companies, most with a strong global footprint, also aren't thrilled about all of this.
The cycle continues: Fed officials have said they'll likely continue rate hikes into 2023, so there's little relief coming. "The dollar could inch even higher if not countered by more assertive moves particularly by the European Central Bank (ECB), which meets this week to deliver a second rate hike to combat rising inflation within the Eurozone," said Quincy Krosby, Chief Global Strategist for LPL Financial.
Bad for business: S&P 500 companies that have a global footprint also have to deal with the strong dollar making a dent in their revenue growth. About 30% of all S&P 500 companies' revenue is earned in markets outside the US, said Krosby. During earnings season, a number of companies said that the strength of the dollar had already hurt revenue growth.
LPL Financial estimates that the strong dollar took 2 to 2.5 percentage points out of S&P 500 revenue in Q2.
The bottom line: The strength of the dollar should stop accelerating when the Fed stops hiking, said Krosby. But there are outside forces that could keep the USD's value sky high even after the FOMC calls it a day: The current weakness of the euro and other currencies isn't just about the Fed. It also reflects fears from investors of an impending recession in Europe. They're flocking to the safe haven that is the dollar, at least for now. Expect the greenback to stay strong for a while.
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