Marcus Ashworth
"It's our currency, but it's your problem," was the 1971 message from John Connally, Richard Nixon's treasury secretary, to U.S. trading partners dismayed by the dollar’s then weakness. What was true then remains true today, albeit in the opposite direction with the greenback having risen 6% in April and 13% in the past year to its strongest level for two decades against a basket of major currencies. The Federal Reserve needs to be mindful of the threat to global growth posed by the U.S. currency’s rapid ascent.
The greenback is the logical haven for investors seeking financial refuge from a confluence of global shocks that started with the pandemic and has been intensified by Russia's invasion of Ukraine, culminating in an energy and food price surge. King dollar rules supreme as the Fed maintains a policy of benign neglect in the currency market, having provided almost limitless access to dollar liquidity for central banks around the world in the past two years.
Bar a handful of outliers, including the Brazilian real and the Peruvian sol, the dollar is omnipotent versus pretty much every currency in both the developed and developing world. That’s putting the squeeze on policy makers everywhere to defend their currencies or risk importing yet more inflation into their already beleaguered economies.
The Fed’s monetary policy is dictated by the needs of the domestic economy. With inflation, the most important element of its mandate, surging by 8.5% in March, the U.S. central bank is expected to follow March’s quarter-point interest-rate rise with accelerated half-point increases starting this week. The futures market anticipates a Fed funds rate of at least 2.5% by year end, up from 0.5% currently; the dollar’s ascent reflects expectations for a shift in interest-rate differential with other countries.
The stronger dollar is also doing the Fed's work in combating inflation by tightening financial conditions on a trade-weighted basis. Although the U.S is the world's largest economy and a huge importer of goods, it is relatively insulated from the global energy and food price shock by its domestic production of fuel and foodstuffs. It also benefits because all major commodities are priced in dollars. It's everyone else's problem if raw materials suddenly become more expensive in their respective currencies.
The world has suffered bouts of an overly strong or weak dollar several times during the past half-century. The explosion in oil prices in the 1970s culminated in a global recession, exacerbated by the aggressive rate hikes implemented by Paul Volcker’s Fed. His inflation-beating policies in turn resuscitated the dollar into the mid-1980s: The perceived advantage that delivered to the exporting nations of Japan and Europe versus American industry led to the 1985 Plaza Accord, which dramatically reversed the dollar’s strength and boosted the U.S. economy at the expense of other nations, particularly Japan.
The current weakness in the currencies of Japan and Europe would typically be welcomed for juicing their exports. But the recent slippage in the Chinese yuan, the world's second-most important trade-weighted currency, puts matters into a different league. All three regions are facing an unusual and potentially intractable problem of imported inflation. There’s a clear and present danger of rising prices slowing global economic growth to the extent that a recession is possible, and stagflation a real risk.
"The dollar's rally is like an uphill avalanche,” according to Kit Juckes, a currency strategist at Societe Generale SA. “Just as an avalanche picks up snow, rocks, trees and anything else in its path as it slides down a mountain, the dollar's rally has the knock-on impact of causing more currencies to weaken. A broad-based move, though, tightens global monetary conditions, and so downside economic risks grow.”
At some point this will start affecting the U.S. economy and become relevant to Fed decision-making, but that could take a while. Sure, U.S. gross domestic product surprised on the downside by declining at an annualized rate of 1.4% in the first quarter. But this was due to a surge of net imports, no doubt helped by the extra purchasing power of a stronger dollar, combined with a slump in exports.
With the Fed's balance sheet still at nearly $9 trillion, there are plenty of dollars swimming around. The central bank is expected to start actively selling its bond holdings, possibly as soon as this summer, which may reduce overall liquidity and, counterintuitively, make the dollar less of a haven. Fewer dollars should in theory boost its value, but the world needs to become a better, safer place before the greenback's uptrend meaningfully reverts. For the sake of the global economy, here's hoping King Dollar’s crown starts to slip.
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