Accessing liquidity to cope with King Dollar
All things being equal, rising interest rates make currencies more attractive to investors, thereby causing exchange rates to rise. These forces have been on display in 2022, pushing the US dollar to multi-year highs against other major currencies. The dollar is also benefiting from its status as a safe haven at a time when the world is wracked by inflation and geopolitical stress, and major economies appear to be heading for a recession.
Admittedly, the dollar’s current run started from a relatively weak starting point. The greenback hit its lowest level in more than five years in May 2021, when markets still believed the US Federal Reserve (Fed) would keep its benchmark interest rate near zero for the foreseeable future.
But as inflation picked up, fuelling expectations that the Fed would begin raising rates — which it eventually did at a rapid clip starting in December 2021 — the dollar embarked on a steady ascent which has seen it breeze past 20-year highs against the euro, yen and pound sterling this year.
The strength of the US dollar in the face of a decidedly gloomy global economic outlook underscores its status as the world’s dominant reserve currency. It also highlights how far the Fed’s policy decisions can reverberate around the world. Right now, the Fed’s determination to tame inflation at home is causing widespread pain abroad, as well as hurting US exports and reducing profits earned overseas by US companies in dollar terms.
Heavy is the crown of dollar dominance
The dollar’s strength comes from its function as the world’s reserve currency and the unit of exchange for most global commodities and a big chunk of global trade. According to a study carried out by the International Monetary Fund, an estimated 40% of the world’s trade deals are carried out in dollars.[1]
Energy and food commodity prices have already risen sharply this year as a result of supply shocks that were exacerbated and prolonged by the Russia-Ukraine war. But countries whose currencies have declined against the dollar face even steeper bills. They also must contend with ballooning payments on their US dollar-denominated debt.
For many emerging market economies, the higher cost of dollar borrowing negates the benefits of the export boost they get from having a weaker currency.[2] And exporters in many developed nations are also unable to take full competitive advantage of a favorable exchange rate because their output is constrained by energy disruptions.
The trade-weighted average of the dollar has risen relentlessly this year
In short, beyond American travelers benefiting from cheaper holidays abroad, there are few unequivocal winners from the strong dollar or the interest rate hikes driving it. In the past 40 years, rapidly rising US rates have been one of the primary triggers of international financial instability and are now being viewed as a major threat to the global economy as other central banks are forced to raise their own rates to defend their currencies.[3]
How can investors respond?
Currency hedging or investing in funds that maintain constant hedges is one strategy, which, while not necessarily a means of outperforming, does help minimise volatility.
Alternatively, some suggest that the dollar may have overshot, creating an attractive buying opportunity in international holdings — though that must be weighed against the risk from higher dollar-denominated debt repayment burdens.[4] Valuations are also an important metric to think about: there is now more value in value stocks than in any other cycle since 1990.[5]
Pursuing any of these strategies has become more challenging in light of tightening liquidity conditions. Securities-backed financing provides an attractive solution to access liquidity when capital is in short supply. It provides a source of funding investors can use to diversify their positions to other geographies and sectors or obtain currency hedges. Importantly, they can do so without sacrificing the upside potential of their core holdings, which they can keep hold of and only consider selling once liquidity conditions improve.
When might the dollar weaken?
The dollar could lose steam once the US decides inflation is under control and eases off the monetary brakes – something it has ruled out until at least the end of 2022. Atlanta Fed President Raphael Bostic suggested rate hikes might be paused once the policy rate reaches between 4% and 4.5% by December.[6] Given that inflation, employment and business activity in the US are all stronger than in other major economies in Europe and Asia, that gap also needs to narrow for the dollar to weaken. And because the US is a net energy exporter, a tempering of global energy prices would also help rein in its currency.[7]
Investors need to closely watch these signs, but trying to accurately predict currency markets can often be a fruitless endeavor for even the most seasoned currency experts. With access to a flexible source of capital, investors can remain nimble and rebalance their portfolios in response to the dollar’s ebb and flow.
[1] https://www.imf.org/en/Publications/WP/Issues/2020/07/17/Patterns-in-Invoicing-Currency-in-Global-Trade-49574-print-pdf.pdf
[2] https://www.economist.com/finance-and-economics/2022/09/08/why-the-dollar-is-strong-and-why-that-is-a-problem
[3] https://www.reuters.com/markets/europe/dollar-shock-threatens-global-economy-2022-09-30/
[4] https://www.morningstar.com/articles/1101202/whats-the-impact-of-the-strong-dollar-on-my-portfolio
[5] https://www.morningstar.com/articles/1101202/whats-the-impact-of-the-strong-dollar-on-my-portfolio
[6] https://www.marketwatch.com/story/feds-bostic-wants-to-pause-after-december-rate-hike-11665003566
[7] https://www.eia.gov/energyexplained/us-energy-facts/imports-and-exports.php
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