Liz Looks at: the US Dollar
By: Liz Young · November 18, 2021 · Reading Time: 4 minutes
US Dollar Making a Holler
The U.S. Dollar (USD) spot index recently hit its highest level since July 2020 after a swift run-up between the beginning of September and mid-November. Still well off its highs of 2020, the recent move up is notable after the currency seemed to be stuck at a lower level for the first half of the year.
Here’s my take on what’s driving it, how it affects other assets, and what’s next in the dollar move.
In the Driver’s Seat
Stop me if you’ve heard this before…inflation is high. One of the main factors that drives movements in the USD is inflation — in this case, consistently elevated inflation readings that lead market participants to believe the Federal Reserve will have to raise rates sooner rather than later. When rates rise, it stimulates foreign investment because the rate offered here is higher than those offered abroad, and in turn, the currency appreciates.
One way to look at forward expectations of inflation is the differential between Treasury Inflation Protected Securities and nominal Treasuries (the inflation rate that would make an investor indifferent between the two is the breakeven inflation rate). The higher the breakeven rate, the higher investors expect inflation to be over that period.
Since the end of September, the two-year breakeven inflation rate has increased from 2.5% to 3.5%. That rate was below 2.0% at the end of 2020. Big move in inflation expectations = big move in the USD.
What’s In It For Me?
This is the investor’s conundrum. Simply stated, there are two main environments in which the USD increases: 1) when the U.S. economy is doing better than other economies, 2) when people are afraid and piling into safe-haven assets.
I would argue we’re more in the first camp than the second, but there are elements of both present. So what does that mean for other asset types?
Some main effects a stronger USD has on other assets:
• Commodities denominated in USD become more expensive and could see a decrease in demand
• Companies with higher international revenue exposure get hit with foreign exchange costs (40% of S&P 500 companies’ revenue comes from abroad)
• Emerging Market economies that issue debt denominated in USD face higher interest costs
All of these things could happen if the USD strengthens further or stays relatively strong vs. other major currencies. But the main question is, will this run-up last?
The Holler Fades
As long as inflation expectations run hot and we are antsy about rate hikes, the USD is likely to see periods of strength. Over time though, I think this strength fades for three reasons. First, because goods inflation will eventually relax from these high levels as supply chain issues are resolved (although I still believe overall inflation stays higher than pre-pandemic levels, but that’s a column for another week). Second, because the twin deficit issue in the U.S. (current account deficit and budget deficit) keeps a lid on its potential. And third, because we have a new option to consider in times of high inflation and monetary policy changes: crypto. Together, I see those factors as limiting demand for the USD and coming back into view in the first half of 2022.
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Communication of SoFi Wealth LLC an SEC Registered Investment Adviser. Information about SoFi Wealth’s advisory operations, services, and fees is set forth in SoFi Wealth’s current Form ADV Part 2 (Brochure), a copy of which is available upon request and at www.adviserinfo.sec.gov. Liz Young is a Registered Representative of SoFi Securities and Investment Advisor Representative of SoFi Wealth. Her ADV 2B is available at www.sofi.com/legal/adv.