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The strength of the US currency has amplified already existing headwinds for the world economy. But while central banks have kept up the fight to protect their currencies from depreciation, a USD reversal is something only the Fed will be able to engineer.

In a world rattled by broad geopolitical tensions, shrinking liquidity, and record-high inflation rates, investors have turned to the US dollar. 

With the traditional 60/40 portfolio currently on track to record its worst year since the 1970s, the dollar has been one of the few assets holding its ground as a diversifier. 

The trade-weighted US dollar index rose to a 20-year high in the third quarter of this year and has appreciated against all but eight out of 50 currencies Western Union Business are tracking. 

But unlike the 1980s, when the G5 nations decided to coordinate a weakening of the US dollar in the Plaza Accord, the US is now welcoming the appreciation of its currency. 

A stronger currency does not only offset rising import prices, but it also helps tighten financial conditions, aiding the Fed in its fight against inflation. But that which has helped the Fed doesn’t necessarily bode well for the rest of the world, which is struggling with an energy crisis and rapidly shrinking FX reserves. 

us currency

How US currency affects the domestic trade landscape

It is important to note that a strong dollar has negative side effects for the United States as well, as it affects corporate profits. 

S&P500 companies make about 40% of their sales outside the US, which might partially explain why stocks of domestically-oriented companies have so far outperformed more global businesses this year. However, domestic problems pale in comparison to what USD strength is doing to the rest of the world.

For starters, the dollar is negatively correlated with world trade, which is mainly explained by the fact that around 40% of global commerce is priced in USD. 

Based on the dollar’s performance and other leading indicators, world trade growth is expected to turn negative in the fourth quarter of this year. 

The damage extends to emerging markets (EM) as well. Central banks have tried to defend their currencies against the US dollar by running down foreign currency holdings. 

This year, the fight against depreciation has already drained their FX reserves by more than $400 billion. This has raised the possibility of currency crises in selected countries with a large share of dollar-denominated debt and is one reason international investors have fled emerging market stocks and bonds at the fastest pace since 2005. 

Looking into the next year, investors are starting to wonder how much room the dollar has for the upside.

Despite some recent losses, the Greenback is still up 19% since May 2021. 

However, following leading economic indicators and macroeconomic uncertainty indices, it becomes clear that a large part of the dollar’s uncertainty- and volatility-driven strength has passed; the currency is already pricing in a majority of the expected global economic slowdown. 

The peak uncertainty theme, however, does not mandate a fall of the dollar but simply changes the dynamics driving the Greenback. 

future of USD

The future of USD 

Going forward, the dollar will need to draw its strength from other factors, such as the potentially unaccounted-for weakness of the global economy. Alternate options include continuing to reprice US interest rates higher.

Given the vulnerabilities of other major currencies, it would be possible for the dollar to remain at elevated levels while not reaching new highs in 2023. The global energy crisis is still impacting currencies like the euro, pound and yen in a negative way and monetary policy will continue to favour the dollar in 2023.  

A turnaround of the US currency would be welcomed by financial markets but is primarily dependent on three critical conditions:

  1. Geopolitical tensions and commodity prices would have to ease, helping the energy-importing countries’ currencies recover some ground.
  2. The Fed would have to signal an end to its tightening cycle and show a willingness to cut rates next year if policy easing is needed to support economic activity. 
  3. A sustained fall in market volatility would facilitate capital rotation away from the US dollar into riskier currencies, yielding more interest.

While we see inflation and, therefore, volatility starting to peak in most countries, a return to the environment before the pandemic or even 2022 is unlikely to occur next year. 

Even though periods of extreme uncertainty are short-lived, above-average volatility caused by a shortage of liquidity, can be sustained for some time. 

Peaking inflation might limit the scope of central banks to raise interest rates any further next year but being less hawkish does not translate into being dovish. The threshold for central banks to start buying bonds again has clearly been raised in a high-inflation environment. This sets a new regime.

The financial world is hoping to see a triple peak in inflation, interest rates and the US dollar. But will we hit the trifecta next year?