• Eng Guan

The Supreme Dollar Is Both A Gain & A Pain

I recalled going on my business trips to the US back in 2002 and 2007. USDSGD was trading around 1.70 and 1.50 then. And just when you thought it couldn’t get any lower, it plunged dramatically after the Great Financial Crisis in 2008 triggered one of the largest monetary easings in history. USDSGD dropped near 1.20 in 2011 at its lowest point and was one of the weaker currencies then.


This year, however, USD reigns as the undisputed champion while almost every other asset bathes in a sea of red. USDSGD has since rebounded back to 1.43. It may not seem like a big deal. But that is only because SGD has been strong relative to other currencies. With deep reserves, the Monetary Authority of Singapore (MAS) has been able to prop up the SGD and prevent it from weakening too much. The situations with other countries are, however, not as optimistic. Other G10 currencies, which collectively represent the world’s most heavily traded currencies, are falling far behind the USD. The Euro has breached below parity against the USD. Even the once supreme Great British Pound had approached dangerously close to parity as well.


The chart below shows you how some of these currencies stacked up against the USD this year.


SGD and some G10 currencies against the USD in 2022 (Source: Yahoo Finance)
SGD, CNY, and some G10 currencies against the USD in 2022 (Source: Yahoo Finance)

What is Driving The Dollar Strength?


Currency is the largest and most actively traded asset class globally. Persistent strong trends are almost always driven by the same few factors. And so is the case for the dollar.


1. The US interest rate is getting more attractive

The US Federal Reserve, which has consistently been behind the curve, played catch up this year. The inflation they discounted as transitory prior to 2022 soared to new highs. And being late to react, they floored the pedal and started hiking rates at one of the fastest paces in history. If all goes according to what the market expects, the Fed Funds rate will hit 4.5%-4.75% at the end of the year. To put things in perspective, we started near zero at the beginning of the year.


Even though central banks across the globe are also pushing up interest rates to fight inflation, they still trailed behind the US. This leads to a widening differential between US interest rates and theirs. In simpler terms, it just means it is getting more attractive to hold USD relative to other currencies because the US now pays a higher interest rate. This results in funds flowing from other currencies toward USD or USD-denominated assets. And this puts upward pressure on the dollar to rise.


Central Bank Interest Rate Movements
Central Bank Interest Rate Movements

2. The US is in better shape than its peers

Even though the US economy is slowing, it is still in better shape when you compare it with Europe, the United Kingdom, or Japan. The conflict between Russia and Ukraine, in particular, is bearing down on Europe aggravating energy problems and inflationary pressures, making lives difficult for its people. A stronger economy attracts inflows and strengthens the country's currency. While I would not say the US is anywhere near being in a good shape, it is nonetheless stronger relative to its peers.


3. The US is still the global safe haven

When a global crisis hits and risk aversion rise, money still flows toward the US. It is just a matter of which asset people choose to park their money in. As it is, the US is still the world's largest economy and the USD is the largest global reserve and trade currency. When all else fails, it would seem a safe bet that the US will be the last to fall. And even though US Treasury bonds, one of the most popular safe havens, have been buckling this year under the dual impact of inflation and rising rates, the yields across the entire curve are becoming more appealing. As of the time of writing, the yields for Treasuries with a duration of 6 months or longer are now sitting above 4%.



The Impact of a Rising Dollar


A rising dollar is a boon for some and a misfortune for others.


For foreign investors who hold USD cash or USD-denominated assets, the strength of the dollar is much desired. In fact, other than commodities and volatility, the dollar is probably the only other asset that is able to produce any gains this year. To give you a sense of the magnitude, if you are from Singapore, you have gained close to 6% just by parking your money in USD cash this year. And if you hail from Japan, you just made an astounding 27%! Even if you are holding US stocks, bonds, or REITs, any losses on such assets are at least partly cushioned by gains from the dollar when translated back to your home currency. Similarly, companies with revenue from the US will stand to benefit.


While a stronger dollar is beneficial to the US in taming inflation by making its imports cheaper, unfortunately, it poses a problem for other countries. Because global commodities such as crude oil, natural gas, wheat, corn, or any imported goods which are denominated in USD become more expensive for these countries. This adds to their woes when they already had enough trouble fighting high inflation.


The same goes for those who owe debt denominated in dollars. Any foreign entity or country, developing nations, in particular, that borrowed in USD will find its burden increasing and may run into trouble servicing its debt obligations.


Where Will The Dollar Head Next?


The strength will likely persist in the short term as the US will continue hiking its rates if things go as planned. At the moment, the Federal Reserve is prioritizing the fight against inflation over all other things. And the relative strength of its economy puts it in a better position to do so than others. The widening gap between the interest rate of the US and other countries will support the strength of the greenback. However, that may wane once the Federal Reserve slows or halts the hikes and the rest catches up and narrow the gap. Things can also take a quick turn if the Federal Reserve reverses its course or if the central banks of other nations intervene with a more coordinated response to halt or slow the rising dollar.


 

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