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.
