How A Stronger Dollar Impacts The US Economy

The U.S. Dollar Index, which measures the value of the U.S. dollar against a basket of foreign currencies, has gained about 3.2 percent year-to-date through Oct. 11. 

This is where the greenback stands year-to-date against other major currencies:

• Euro: +3.4 percent
• Pound: +2.1 percent
• Yen: +0.5 percent
• Australian dollar: +8.63 percent
• Canadian dollar: +3.5 percent

Even against the tightly controlled yuan, the dollar was up 5.9 percent. Every morning, the People's Bank of China sets the midpoint for the trading band for the day and the yuan is allowed to move up or down merely 2 percent.

The greenback's gains against emerging market currencies have been steeper.

The MSCI Emerging Markets Currency Index, which tracks the performance of 25 emerging market currencies against the U.S. dollar, has declined 5.5 percent. The Indian rupee has depreciated about 16 percent against the dollar, and the Mexican peso is down 3.4 percent.

Factors Impacting Currency Moves

• The strength of the economy: A stronger economy attracts investment into the country, boosting demand for the currency and translating to currency strength.
• Geopolitics: Geopolitical risks such as elections, natural disasters, economic policy announcements and wars are likely to stir up uncertainty, reducing the appeal of a nation's currency.
• Trade: When a currency runs up a trade deficit — when imports are more than exports — it has to buy more foreign currency to buy goods, while foreigners may have to buy less of the nation's currency, depressing its value. On the contrary, if trade terms improve, a nation has to buy less foreign currency, while at the same time demand for its currency among foreigners increases, firming it up.
• Inflation: A higher inflation rate reduces the value of currency. Inflation suggests a rise in prices, which makes the goods and services of a nation less competitive in global markets. This in turn weighs down the value of the currency.
• Interest rate differential: Higher interest rates attract foreign inflows, boosting the currency, and vice versa.
• Debt: Higher national debt adversely affects currencies.

One Driver: Interest Rate Differentials

The Federal Reserve's tightening of monetary policy is one of the reasons behind the dollar's rally. After maintaining the federal funds target rates at extremely accommodative levels of zero to 0.25 percent from December 2008 to December 2015, the central bank began raising rates in small increments.

The fed funds target rate is currently at 2-2.25 percent following three quarter-point hikes so far this year, while the European Central Bank's refinancing rate is zero. The Bank of Japan's main policy rate, the overnight call rate, is at a negative 0.1 percent. 

This interest rate differential between the U.S. and most other economies has rendered U.S. assets attractive, leading to investment inflows into the U.S. to take advantage of higher rates.

A Robust Domestic Economy

The U.S. economy has been on a firmer foundation, although much of the strength is attributable to stimulating measures such as tax cuts.

Final second-quarter GDP estimates released by the Bureau of Economic Analysis show that the U.S. economy expanded at an annualized quarterly rate of 4.2 percent.

In comparison, the latest GDP estimates from the eurozone show 0.4-percent growth for Q2. The Japanese economy expanded 1.9 percent during the same period.

Trade War Chatter

President Donald Trump's imposition of tariffs on imports and threats of more to follow have triggered concerns about the hit to overseas economies — which has also contributed to the dollar's strength.

Other reasons include repatriation of overseas corporate profits, a move facilitated by the tax break signed by Trump. 

Stronger Dollar, Weaker Commodities

An unintended corollary of a stronger dollar is weakness in commodities, which are mostly dollar-denominated. When the dollar firms up, one can buy more of a commodity with the same dollar amount, trimming the demand for that commodity and in turn the price.

What A Stronger Dollar Means For The Economy

When the dollar is firmer, its purchasing power increases, as it can buy more imports denominated in overseas currencies.

Exports Tend To Fall

A stronger dollar affects exports in two ways:

• Exports become expensive relative to offerings from other nations, reducing their competitiveness.
• Export earnings translate to less dollars in the hands of exporters.

Inflation Falls 

A stronger dollar reduces the prices of imported goods into the U.S. This in turn forces down prices of higher-priced equivalent domestically-produced goods, bringing down inflation.

Yet the relationship holds true primarily when an economy is experiencing a boom, characterized by high growth and high inflation. During a recession, a stronger currency will reduce aggregate demand due to non-affordability, worsening the downturn.

See also: What's Behind The Divergence Between The US, Emerging Markets?

Multinationals Suffer

A domestic company with significant operations overseas faces the prospect of falling profits as it loses competitiveness vis-à-vis overseas companies.

Similarly, profits earned in overseas currencies, when repatriated, will translate to fewer dollars in times of a strong dollar. 

Investors in such companies may have to exercise caution. 

Cheaper Foreign Travel 

The greater purchasing power afforded by a stronger dollar allows the purchase of more goods and services denominated in a weaker foreign currency.

Emerging Markets Suffer Backlash

The jitters seen in emerging markets are mostly due to the dollar's strength and its potential impact. A stronger dollar makes its difficult to pay back dollar-denominated debt, making indebted nations default candidates. 

A stronger dollar drives fundflow out of the emerging markets into the U.S., as emerging market investors strive to take advantage of higher yields and higher interest rates in the U.S. This is negative for emerging market stocks.

The Dollar's Near-Term Outlook 

With the Fed fixated on continued monetary policy normalization, the dollar's strength may be here to stay. Yet the rally could see a hiccup ahead of the Nov. 6 midterm election on the grounds of political uncertainty, according to  CNBC, which quoted Derek Halpenny, European head of Global Markets Research at MUFG.

The euro could end the year at $1.18 against the dollar, firmer than the $1.155 level at which it's trading currently, according to the National Bank of Canada. The dollar is expected to end the year at 114 versus the yen compared to 112 now. 

Related Link: Inflation: What It Is, Where It Comes From And How To Protect Your Portfolio From It