Between January and mid-July of 2022, the value of the U.S. Dollar Index rose about
12%.
But during that same time frame, the S&P 500® stock index fell about 20%.
While there are a lot of factors that cause stocks to rise and fall, a strong dollar appeared
to be an important factor during this period.
It might seem like a strong dollar should be good for the U.S. economy and the stock
market, but as usual, it’s not that simple.
Understanding how currency values change and their impact on assets like stocks can help
you navigate the markets when the dollar is strong.
A “strong” dollar means the U.S. dollar’s value is high relative to other currencies.
A number of factors can impact a currency’s strength but typically it comes down to supply
and demand.
One way the dollar can be strengthened is by tightening the money supply.
This is done primarily through the Federal Reserve pushing interest rates higher.
Higher rates make borrowing less attractive and discourages people and businesses from
borrowing and spending, which takes money out of circulation.
At the same time, tightening monetary policy can also increase demand for dollars.
When the Fed raises the federal funds rate, U.S. Treasury bond yields tend to rise, making
them more attractive to foreign investors.
These investors exchange their low-yielding currency for U.S. dollars to buy U.S. Treasuries.
The higher demand for the U.S. dollar increases its value against the investor’s home currency.
For example, in the summer of 2008, it took about 1.6 U.S. dollars to buy one euro.
On July 14, 2022, the dollar and euro were at parity, which means it took one dollar
to buy one euro.
There are other factors that can strengthen the dollar like global economic and political
uncertainty.
In 2022, the Russian-Ukraine war, China’s COVID-19 lockdowns, and talk of a global recession
prompted investors to move into the relative safety of dollars and Treasuries.
All these factors played a part in the dollar achieving parity with the euro.
However, a strong dollar can hurt U.S.-based multinational corporations because it makes
U.S. goods and services more expensive overseas, reducing demand.
Additionally, earnings made overseas are reduced when converted back to U.S. dollars.
For example, IBM beat earnings expectations in July 2022 but said the currency exchange
reduced its revenue by $900 million for the quarter.
According to FactSet, “currencies” were among the top three issues discussed in Q2
2022 earnings announcements.
In fact, currency headwinds can be a problem for the S&P 500 more broadly because it is
made up of many of the world’s largest companies that do business around the globe.
On a year-over-year basis, every percentage point gain in the dollar results in about
a half-point hit to earnings on the S&P 500.
Looking at other asset classes, a strong dollar can also suppress commodity prices because
so many commodities are traded in dollars.
But just like stocks, there are other factors that affect the prices of commodities.
Additionally, the Fed’s rate hikes that can lead to a stronger dollar can cause bond
prices to fall as yields rise.
However, when the Fed starts to slow or end rate hikes, the bond market typically levels
out.
When it comes to international stocks, foreign companies may benefit from a stronger dollar
because it makes their goods and services cheaper for U.S. consumers.
However, inflation and economic slowdowns abroad could offset these benefits.
If you’re wondering how your portfolio might fare in the face of a strong dollar, here
are a few things to consider: U.S.-based multinational companies that get much of their revenue overseas
may be more sensitive to a strong dollar than companies that do more of their business in
the U.S. Additionally, if the strong dollar is accompanied by rising interest rates, bond
prices tend to fall while bond yields increase.
Finally, energy and basic materials may be impacted because a strong dollar tends to
cool commodities.
No matter what you choose to do, these decisions should still be part of a diversified portfolio
tailored to your goals and risk preferences.