How does a strong dollar affect the world economy?

How does a strong dollar affect the world economy?

21 October 2022 from Anna Svahn

Despite high inflation in the US, the US dollar has strengthened both relative to assets such as gold, but also absolutely relative to other currencies, since the beginning of the year. While the DXY is up more than 18 percent this year, most other countries have been big losers. But what effect does a strong dollar really have on the global economy, and is there a limit to when it can become truly harmful?

Despite the USA's share of global exports falling from 14 percent in 2000 to just over 9 percent this year, 40 percent of global exports are made in USD, which has led to a strong USD leading to many countries importing part of the inflation. While developing countries are of course hit the hardest, on average a 10 percent stronger USD relative to the domestic currency has contributed to 1 percent higher inflation in the country.

When inflation in both the US and the rest of the world took off, many thought it would lead to a weaker dollar, but since then the opposite has happened. The simple explanation is the Federal Reserve's crackdown on the inflation problem and that the global inflation problem led to investors selling risk assets and reallocating to US government bonds instead. For Americans, of course, a strong dollar is positive, but for many other countries it leads to reduced purchasing power, higher inflation (as mentioned above) and central banks being forced to raise interest rates more than they originally wanted.

In recent weeks, we have seen how the global financial system is crumbling. After the UK's mini-budget which included tax cuts, the British pound fell and the 30-year yield rose sharply, causing several pension funds to almost collapse, which itself led to the Bank of England having to step in with stimulus purchases to prevent a total collapse. Since then, the budget has been withdrawn and although the GBP has fallen almost 20 per cent year-on-year against the US dollar, it has recovered somewhat from the fall at the end of September.

In the EU area, inflation continues to rise strongly and the Euro weakens, but even so, the ECB cannot raise interest rates as strongly as the FED because most of the inflation is asset-driven from the energy side, and further increases would most certainly force the entire EU into a recession.

In other words, the outlook looks bleak, and the hope investors are leaning towards is that the US economy would shrink so sharply that the Federal Reserve is forced to make a pivot and thereby both lower interest rates and perhaps start support purchases again. The problem with that logic is that such an outcome is hardly positive for the economy. The other problem is that the Fed itself has been very clear that there will not be a change in their policies in the near term, but that they will raise interest rates and tighten policy as much as they need until inflation falls back.

It will be a long time before we are back at inflation levels of 2 percent or below again. Until then, we have to get used to "higher for longer" for both interest rates and inflation. And for those who buy risk assets based on a hope for a pivot from the Federal Reserve, Daniel Lacalle, professor of global economics, writes:

"Investors should not care whether the Fed pivots or not if we analyze investment opportunities based on fundamentals and not on monetary laughing gas. Betting on a Fed pivot by adding risk to cyclical and extremely risky assets may be an extremely dangerous position even if the Fed does reverse its pace because it would be ignoring the economic cycle and the earnings reality. If we look to build portfolios for the long term, we need to pay attention to the reality of the economic cycle and inflation and stop believing in fiscal multipliers and monetary fallacies that never work.

Central banks do not print growth. Governments do not boost productivity. However, both perpetuate inflation and have an incentive to increase debt. Adding these facts to our investment analysis may not guarantee high returns, but it will prevent enormous losses.”

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06/02/2023 00:26:37

 

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