Why Is the U.S. Dollar So Strong? Will It Continue?
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, how to live without worrying about it. I'm your host, David Stein. Today's episode 404. It's titled, Why is the U.S. dollar so strong? Will it continue?

The U.S. dollar is the strongest it has been since the year 2000. By strong, I mean the U.S. dollar is worth more when converting it to a different currency. The U.S. dollar can buy more when you exchange it and then try to buy things in a different country. A strong U.S. dollar means imports into the U.S. are cheaper and exports from U.S. to other countries are more expensive.

including the massive food exports that the U.S. sends around the world.

Last week in our weekly email newsletter, The Insider's Guide, I wrote about how Japan hadn't opened up its country to let in foreign visitors. The next day they did. And a few days after that, my son, my oldest son, booked a trip to Japan. I mentioned he'd been trying to get back there for a number of years but wasn't able to. It's an excellent time to travel to Japan because the

The yen is the weakest it's been relative to the U.S. dollar since 1998, which means Camden's money will go further when he visits Japan here in a few weeks. Last week, the British pound fell 4% relative to the dollar in one day.

King dollar is how Financial Times columnist Kate Martin put it. Esward Prasad, an economics professor at Cornell, wrote, For the rest of the world, it's a no-win situation. The strong dollar is what he's referring to.

Patricia Cohen in the New York Times wrote, In Nigeria and Somalia, where the risk of starvation already lurks, a strong dollar is pushing up the price of imported food, fuel, and medicine. The strong dollar is nudging debt-ridden Argentina, Egypt, and Kenya closer to default and threatening to discourage foreign investment in emerging markets like India and South Korea.

What happened such that the U.S. dollar is so dominant, so strong? Just four years ago in episode 215, that episode was titled, Is a Dollar Collapse Coming? We reviewed the work of Peter Schiff, who felt that the dollar was going to weaken tremendously against other currencies. Instead, the U.S. dollar is 20% stronger today than it was back in 2018.

We want to review what's going on with the dollar relative to other currencies. What are those forces and what, if anything, can we do about it? Let's revisit how we got to where we are. We had the pandemic and that led to some supply shocks. The ability for businesses to ship, to produce because so many had COVID, that constrained supply.

It constrained the ability of companies to produce. Now, we've also had some supply shocks this year from Russia. Its invasion of Ukraine has disrupted global supply, particularly for natural gas flowing out of Russia to Europe. The price of natural gas has skyrocketed. We've also had demand shocks.

With COVID, there was a shift of in-demand toward goods, patio furniture, for example, other things for people's homes, rather than services, the ability to travel. Now we're seeing more travel, and that has pushed up the price of airfares and hotels.

We also saw increased money supply from government programs around the world to provide stimulus to households and businesses to overcome the COVID shock. In many countries, such as the U.S., that stimulus was combined with quantitative easing, where central banks bought up government bonds and effectively monetized those stimulus payments, which means that

The central bank created the money that then flowed to households and businesses. An increased money supply can push up prices and cause inflation. We've also had very low interest rates to negative interest rates after adjusting for inflation. That encouraged borrowing and risk-taking.

People wanted to buy homes. They had more money. They were able to borrow easily at very low rates. That pushed up home prices, which now has led to higher rents for homes and for apartments. All those things have led to the highest level of inflation in 40 years. Reduce supply or supply constraints, demand, and

and households and businesses with money to fuel that demand and a greater money supply. Inflation has gotten out of control, and that has led central banks to raise their policy rates, which are overnight borrowing rates between banks. In the U.S., it's called the Fed Funds Rate.

When central banks raise their policy rate and provide communication on the direction of those policy rates, that can lead to higher longer-term interest rates. Higher long-term rates discourages borrowing. Why would someone go out and sell their house when they have a 3% mortgage rate and now want to go buy a new one, take out a new mortgage, and have to pay over 6% for a 30-year mortgage in the U.S.?

People aren't moving. They're not going to go out and buy new patio furniture for that much bigger patio. Rising interest rates discourages demand, but it doesn't necessarily improve supply. So it takes time for these higher interest rates to take effect. It takes time for companies to be able to increase supply to meet demand, but it has led to a period of high inflation.

And what has been particularly disconcerting this round is central banks started off slow in raising their policy rate. They thought the higher inflation was transitory. It was just because commodity prices had risen and as supply-demand balances corrected, that inflation would come down.

That hasn't been the case yet. Eventually, inflation should come down. But the risk is because central banks are having to raise policy rates faster and potentially to a higher level than they have, that significantly increases the risk of recession. Capital Economics, an economic research firm, looked at the 81 times that central banks around the world...

have raised their policy rate since 1960. When those rate increases have been between 2% to 4%, there were recessions in 14 out of 40 cases. However, when central banks got behind, and had to raise rates more aggressively to where core inflation got over 3%,

81% of the time, there were recessions. And the economic contraction was deeper. The pace at which central banks are increasing policy rates is the fastest in three decades. If we look at where policy rates are around the world, the U.S. has really the highest that I see for developed markets. The current policy rate is...

between 3% and 3.25%, and the expectation is at the Federal Reserve's Open Market Committee November meeting, they'll increase the rate again by 0.75%. If we compare that to the Eurozone, their policy rate is only 0.75%, much, much lower. The UK is at 2.25%. Australia at 2.3%. Switzerland,

a half percentage point. Sweden, 1.75%. Norway, 2.25%. Policy rates are much higher in the U.S. Even some emerging market countries, the policy rates are lower. China's at 2%. South Korea is at 2.5%.

Now, there are countries that have much higher policy rates, developing markets. India's at 5.4%, Brazil's at 13.75%, Mexico's at 8.5%.

One reason those emerging market countries have higher policy rates is they're raising the rate to hopefully keep their currency from weakening so much relative to the dollar to attract investors that are willing to sell dollars and buy Mexican pesos and invest in their country to help prop up the currency.

Over the past three decades, policy rates have generally been coming down. Back in the early 90s, the weighted average policy rate in developed economies around the world was around 8.5%. In the year 2000, the last time the dollar was this strong, the weighted average policy rate was around 4.5%. It was 4% in 2007, right before the great financial crisis.

The policy rate during the last tightening cycle, right before COVID, never got above 1%, the weighted average policy rate. And now we're just about 1% to 1.5% as the weighted average policy rate. The impact of rising interest rates is causing turmoil. Asset prices are falling, particularly for stocks.

Global stock market, the MSCI All-Country World Index, has fallen 8.5% just this month, 25% year-to-date. It returned negative 22% in the past year. Those horrendous short-term numbers bring down longer-term returns. Global stocks have only returned 4.1% annualized over the past three years and 4.9% annualized over the past five.

That includes the double-digit returns last year. The 10-year return is a little better at 7.4% annualized.

Higher interest rates cause borrowing costs to increase, makes it more difficult for companies to borrow and service debts and households. That can slow demand because purchasers are less likely to borrow, as we gave an example of less likely to go buy a house or finance a car because of higher interest rates.

That can impact corporate profits because revenue isn't growing as fast. The same time, companies face higher interest expense, which could also lower profits. We're seeing more companies disappointing when it comes to earnings.

On September 15th, Federal Express, they're a Memphis-based parcel service, global company, they announced their revenue for the three months ending August was $800 million short of what they said it was going to be just a few months ago. It was a huge miss. They now say earnings for the year will only be $3.44. Before, they were saying it would be $5.14.

Their net income dropped by more than 20%, and their stock fell over 20% just on September 15th. FedEx's CEO blames it on the economy. One analyst asked Raj Subramanian, who is the CEO, how did it catch you so off guard? The miss was so huge that analysts believe it can't just be the economy.

We don't know, but that's an example of weaker corporate profit growth having a negative impact on stock prices.

Other reasons that rising interest rates can cause asset prices to fall is the valuations of those assets can decline. When we can now go out and earn 3% on a money market account or buying a treasury bill, that means we want a higher return on other asset classes that are more risky.

The way to get a higher return on an asset class is the price needs to fall. If you pay less for something, you potentially will earn a higher return. So those demands for higher returns have led to falling asset prices. And it's done mathematically through an intrinsic value calculation.

The intrinsic value of an asset is a function of its future cash flows and what those cash flows are worth in today's dollars. That's known as a present value calculation. Higher interest rates lead to lower present values because in order to figure out what those future cash flows are worth today, we have to discount them at some interest rate.

And as interest rates go up, that discount rate goes up, leading to a lower present value because that discount rate reflects the cost of capital, what investors want to earn. When they want to earn more on their investment, it lowers the intrinsic value because their expected return is higher. It requires the asset prices to fall.

So we have interest rates increasing. It has led to a spike in volatility, both for bonds and for stocks. And we've seen drawdowns in stocks, bonds, equity REITs, preferred stocks, and pretty much every asset class except for the U.S. dollar.

And that strengthening dollar makes our returns look even lower when we invest overseas and convert that return stream back into U.S. dollars. The MSCI All-Country World XUS Index, so it doesn't include the United States, has returned negative 26.4% year-to-date.

The actual return before converting it back to U.S. dollars in local currencies is only negative 15.5%. In other words, the non-U.S. stock market has actually done better than the U.S. stock market. Japan, in yen, is only down 6.5% year-to-date, whereas U.S. stock market is down close to 24%.

The UK stock market is actually positive up 0.5% in pounds.

But when we convert it back into U.S. dollars, it's down negative 20% because the British pound has lost almost 20% relative to the dollar. The Japanese yen has lost almost 19% relative to the U.S. dollar this year. And so when we look at the return of Japanese stocks in U.S. dollars, they're down 25.5% year-to-date. Before we continue, let me pause and share some words from this week's sponsors.

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Back in the day, countries used to peg their currencies relative to other currencies. In the late 19th century, early 20th century, they would peg it to the British pound. In the 20th century, particularly after World War II, many countries pegged their currency to the U.S. dollar as U.S. dollar became the reserve currency given the size and strength of the U.S. economy coming out of World War II. That's a lot of money.

That all changed in the early 1970s. In March 1973, Japan and a large number of European countries stopped pegging their currencies against the U.S. dollar. They let their currencies fluctuate based on what investors and speculators were willing to pay, based on trade flows. In theory, allowing a currency to fluctuate gives the country more flexibility.

Because then the central bank can adjust their policy rate based on what's going on with the economy. Rather than having to adjust policy rates to attract capital if the nation's currency is weakening relative to the dollar. Just like an example with Mexico. Mexico having to raise their policy rate to attract capital to prop up the Mexican peso.

In theory, by just letting it fluctuate, countries wouldn't have to do that. But in reality, they continue to sometimes have to adjust their interest rates to prop up their currency. And when they don't, the currency can weaken. Capital is attracted to areas that have the highest risk-adjusted interest rates.

And right now, as we pointed out, the policy rate in the U.S. is much higher compared to other developed countries. What's fascinating, though, is the U.S. economy continues to shrink relative to the rest of the world, its relative weight. In 1992, the United States accounted for just about 20% of world GDP, the monetary value of what was produced in goods and services around the world.

In 1992, developing economies made up 42% of global GDP. And by 2021, U.S. GDP had shrunk to just about 16% of the world's GDP, while emerging markets had increased to close to 58%.

The U.S. is smaller on a relative basis, yet the U.S. dollar continues to play a huge role in impacting the global economy, even though the U.S. is shrinking. Economist and columnist Paul Krugman wrote in the New York Times why this was.

He pointed out once a currency has established global dominance, like the U.S. dollar has, that that dominance tends to become self-perpetuating. Making transactions in dollars is easier and cheaper because so many other people are using dollars. Borrowing in dollars tends to be cheaper because a lot of world trade is invoiced in dollars, and the low cost of financing encourages dollar invoicing.

Most trade is still priced in U.S. dollars because of the ease of converting the dollars and financing those transactions. The economic advisor to the BIS, the Bank of International Settlements, Hyun Song Shin, wrote, "...behind the financial channel of exchange rates is a dense matrix of financial claims in dollars."

The global economy is a matrix, not a collection of islands. And the matrix does not respect geography. All these capital flows going all around the world. And he gives an example. A European bank lending two dollars to an Asian borrower by drawing dollars from a U.S. money market fund. And that European bank has its liabilities in New York and assets in Asia. But its headquarters is in London or Paris.

There are massive borrowings by non-U.S. companies and developing nations in the U.S. dollar. And when the dollar strengthens, that requires more of the local currency to pay off the debt. If your mortgage is in dollars and you earn in yen, your mortgage payment is now 20% higher than it was in yen as you try to convert it to dollars.

That's why it's very risky to borrow in another currency if you don't actually earn money in that currency. So as the dollar has strengthened, that makes it more challenging for households and businesses to service the debt.

That can cause financial stress. That financial stress can discourage non-U.S. banks from lending more in dollars, which makes it more difficult to roll over debt. Financial stress due to the strengthening dollar can lead to an economic slowdown. Not only that, the economic slowdown can lead to fear, a desire to get out of a country and convert to a safer area, such as the U.S. dollar and the U.S. government bond market.

Maurice Opsfeld and Haowen Zhou released a paper last month on the global dollar cycle. They wrote, not only does a stronger dollar itself lead to tighter financial conditions by weakening debtor balance sheets, it also heightens risk aversion in world markets.

Also, heightened risk aversion in world markets tends to appreciate the dollar as investors everywhere seek safety. In other words, a stronger dollar leads to economic weakness, which then encourages an even stronger dollar as investors move their capital back into the U.S. and into dollar-based assets. This dollar cycle has become more pronounced over time.

the past two decades. All of these capital flows going around the world

And as a result, a strengthening dollar can lead to a global slowdown as non-U.S. dollar borrowers struggle to service and roll over debt. It can lead to a risk-off scenario in which investors flee to the U.S., further strengthening dollars. It leads to underperformance of non-U.S.-based assets, stocks. Non-U.S. stocks do better, and the global economy does better when the

when the dollar is weak, not as strong. It's a much more favorable environment for non-U.S. companies because they're able to borrow more cheaply. It's easier for them to service the debt. There are capital flows into their economy, which strengthens their currency relative to the dollar, and it's this virtuous cycle. Now we're in the opposite. The dollar is strengthening, and it's making it very difficult for the rest of the world.

What caused this shift, though, coming out of the pandemic? You probably already know the answer. The Federal Reserve has been earlier and more aggressive in raising its policy rate. The Fed funds rate in the U.S. is 3.25%.

In Europe, it's only 0.75%. That attracts capital to the U.S. to invest, including from hedge funds who can borrow in the Japanese yen or borrow in euro at a lower interest rate and then take those proceeds and invest them in the U.S. That's called a carry trade, and that can further strengthen the dollar like we're seeing today.

There's a study by Ned Davis Research, and that goes back to 1971. And it looks at the U.S. interest rates relative to non-U.S. interest rates. And when U.S. interest rates are higher than non-U.S. rates, the dollar has strengthened on average 2.7% per year. But when U.S. interest rates are lower than non-U.S. interest rates, then the dollar has weakened by 3% per year. So

So interest rates are a primary driver of these trends, relative interest rates that can lead to a strengthening. But you have all of these other additional factors just caused by a stronger dollar or a weakening dollar.

A weakening dollar helps companies around the world as they can borrow cheaper and they can service their debt cheaper. And there's more capital going into those countries, which causes their stock prices to rise.

The other reason, though, the dollar is strengthening so much more today is the impact of Russia's invasion of Ukraine. That is having a much more pronounced impact on Europe and the U.K. due to higher natural gas prices. So even though the U.S. economy is slowing, it appears European and U.K. economies are slowing even more. Now, there have been other factors, government actions. In the U.K., last week, the

The government there announced a program to cut taxes, to increase borrowing, and to provide funds to households and businesses to withstand the higher energy prices. That day, the pound weakened about 4% relative to the dollar, to its lowest level ever. One British pound is equal to $1.04.

I remember back traveling with my oldest son in the UK in May 2008, and one pound was equal $2. Felt like we were paying twice as much for everything. Now we're basically at parity. Back in 1975, one pound was worth $2.40. We have significant weakening of the British pound relative to the dollar, and J.P. Morgan says it reflects an erosion of credibility.

regarding the UK's fiscal policy, their ability to handle debt, how big their budget deficit is. And this goes back to what we discussed last week, structural inflation, higher inflation and higher interest rates because investors are worried about the ability of governments to service the debt and how that can lead to higher inflation.

Now, the British pound was the reserve currency in the 19th century and early 20th century.

But it no longer is because it was overtaken by the dollar, which means there is no guarantee the dollar will continue to be the reserve currency, particularly as we get more of these economic wars as China's economy grows or India's economy grows or countries decide they want to use a different currency for trade. It doesn't look like it's changing anytime soon.

But that doesn't mean longer term the dollar can't weaken. In the shorter term, though, for the dollar to weaken, we need inflation to slow and the Federal Reserve to pause raising interest rates.

Much of core inflation has been driven by rising rents. And data we got last week saw U.S. apartment rents fell last month from their record high. And it fell for the first time in two years. Hopefully that will continue. We'll see. But if inflation comes down, then the Federal Reserve could stop raising policy rates. And if we got into a recession, policy rates could even be cut. What we don't know is...

how deep the recession could be, or we'll even get one. And that's certainly something that we monitor on Money for the Rest of Us Plus. And a worst case scenario is a deep recession, but inflation continues high. Stagflation, because inflation becomes entrenched. Workers demand higher wages. Households and businesses hoard because they believe the

that prices will continue to rise and they lose confidence in central banks and governments to control inflation. And again, that would get us back to that structural inflation scenario. We'll see. We've had a lot of discussions on money for the rest of us plus from members saying, is it really different this time? Yes, we've had inflation. The Fed is raising its policy rate, but are they really going to never do quantitative easing again? Are they never going to

to keep policy rates close to zero again? We just don't know. I don't think things have changed that much. We're just in a unique situation because of the amount of money creation and supply and demand shocks coming out of COVID. The risk is confidence wanes, and we get entrenched inflation. I ponder, what could I have done differently in my portfolio, my investment portfolio?

Traditionally, I just haven't spent a whole lot of time worrying about currency fluctuations. I generally have some hedged non-US equity exposure, but also some unhedged, recognizing that these currency trends, the US dollar can go up and down over time. But if we're seeing essentially a global dollar cycle,

where as the dollar strengthens, it leads to a global economic slowdown, risk-off, further strengthening. Does it make sense to reduce non-U.S. equity exposure whenever the global economy starts to slow, or at least hedge, protect against a strengthening dollar? I don't know, but it certainly got me thinking about that because...

These trends of a strengthening dollar and a weakening dollar seem to go hand in hand with what the global economy is doing. Stronger dollar has generally been periods of slower economic growth and more financial stress around the world. Weaker dollar, greater global financial growth, greater global economic growth, and higher returns for non-U.S. assets. We'll see.

That's our discussion on why the US dollar is so strong. Thanks for listening. I have enjoyed teaching about investing on this podcast for over eight years now, but I also love to write. There's a benefit to writing over podcasting, and that's why I write a weekly email newsletter called The Insider's Guide.

In that newsletter, I can share charts, graphs, and other materials that can help you better understand investing. It's some of the best writing I do each week. I spend a couple of hours on that newsletter each week trying to make it helpful to you. If you're not on that list, please subscribe. Go to moneyfortherestofus.com to subscribe to the free Insider's Guide weekly newsletter.

Everything I've shared with you in this episode has been for general education. I've not considered your specific risk situation. I've not provided investment advice. This is simply general education on money, investing in the economy. Have a great week.