It is perhaps telling that the 30th anniversary of ‘Black Wednesday’ – when sterling was forced out of the European Exchange Rate mechanism on 16th September 1992 – was marked by headlines in the financial press regarding the current weakness of the pound.
There have undoubtedly been domestic factors that have driven Sterling down to 37-year lows against the dollar, not least the weakness of the UK economy, a record current account deficit and doubts about the policies of the government under new Prime Minister Liz Truss1.
However, the UK is not alone in seeing its currency fall sharply against the greenback this year. The euro currently trades close to parity with the dollar2, and the Japanese Yen is hovering around 24-year lows against the US unit3. The US dollar index, which measures the value of the US dollar against a basket of six currencies (the euro, Swiss franc, Japanese yen, Canadian dollar, British pound, and Swedish krona), is up 14% since the beginning of the year and is currently at its strongest since 20024.
In short, the bigger issue from a global perspective is the strength of the US dollar rather than the weakness of the pound. Why is the dollar so strong and what are the implications for the global economy and financial markets?
A high-yielding safe haven
Several factors explain the strength of the US dollar. High yields tend to attract global capital, and as the US Federal Reserve (the Fed) has raised interest rates to a greater degree than most other developed market central banks this year, strong demand for the US dollar has pushed its value higher on the foreign exchanges.
In addition, the dollar’s role as a ‘safe-haven’ currency means that it tends to appreciate during times of heightened uncertainty and market volatility, when investors become risk averse. The war in Ukraine and tensions between the US and China have increased economic uncertainty this year, lifting demand for the dollar.
Furthermore, with the boom in fracking having boosted domestic production of oil and gas in recent years, the US is now a net exporter of energy5. This has been a distinct advantage versus countries that are dependent on imported fuel, most notably those in the European Union which have been overly reliant on Russian exports and now face exorbitant prices along with the prospect of energy rationing. European companies face natural gas prices that are several times that paid by their US counterparts6, hurting their international competitiveness; weaker European currencies provide some offset.
Impact on prices
The strength of the US dollar has far-reaching consequences, some obvious, some less so. Clearly, a stronger US dollar makes exports from the US more expensive and imports in to the US cheaper. This is the case for both goods and services; US tourists travelling to Europe will get more bang for their buck, while European tourists travelling to the US are likely to be shocked by the high prices they face.
The strength of the US dollar will be welcomed by the Fed as it assists in its fight against inflation by dampening the cost of imports, and reducing demand for US made goods and services. According to one estimate from Societe Generale, a 10% rise in the US dollar results in a 0.5 percentage point fall in US consumer price inflation over a year7.
However, the impact on global prices from a strong US dollar extends beyond US shores due to the currency’s role in international trade. As most commodities (e.g., oil, metals, foodstuffs, etc.) are traded in US dollars, a stronger greenback raises the price of these items in the local currencies of countries outside the US. For this reason, dollar strength has added to upward price pressures from this year’s commodity supply shock resulting from the war in Ukraine (see our commentary of March 2022). By way of example, the price of Brent crude has risen around 18% in dollar terms this year, but is up nearly 40% in Sterling8.
Moreover, the upward price impact goes further than just commodities. A recent IMF study noted that around 40% of global goods and services exports are invoiced in US dollars9. Even if commodities are excluded, the dollar share of invoicing, 23%, still exceeds the share of global exports destined for the US, i.e., 10%. Consequently, while a strong US dollar serves to curb price pressures in the US, it can have a disproportionate effect in raising them elsewhere, at least in the first instance.
Tighter monetary conditions
In turn, this can put pressure on central banks outside of the US to raise interest rates themselves in order to support their currencies. Although targeting the currency level will not be the primary aim of most central bankers, policymakers will be keen to avoid an external price shock generating second round inflation effects via the impact on household inflation expectations. This year’s drop towards parity in the euro-dollar exchange rate was probably a factor behind the European Central Bank’s decision to raise rates by 75 basis points earlier this month – the largest in the bank’s history10. Similarly, the recent fall in Sterling to a 37-year low is putting pressure on the Bank of England to tighten monetary policy more aggressively, with one investment bank suggesting UK rates will need to rise to 5% (from 1.75% currently) to arrest the decline in the pound11.
The impact on emerging markets (EM) is likely to be even greater. Not only will a stronger US dollar pressure EM central banks to raise interest rates, but developing countries are also more likely to have taken on debts denominated in US dollars. Many developing economies do not have mature financial markets and institutions that would facilitate largescale borrowing in their own currency at reasonable interest rates. Consequently, they have little option but to borrow in US dollars.
When the greenback appreciates, it becomes more costly to service dollar-denominated debt (i.e., make interest payments, and repay principal) with local-currency revenue streams. What’s more, the Financial Stability Board (FSB) notes that this increased cost can have knock-on effects if governments and large non-financial corporations subsequently turn to the domestic financial sector to obtain the funding they need, reducing credit availability for households and smaller firms12. In turn, these tighter financial conditions are likely to slow economic activity and, in some circumstances, result in default. A strong US dollar, via its impact on raising external debt servicing costs and import prices was, alongside widespread economic mismanagement, a contributory factor to this year's economic crisis in Sri Lanka.
Equity performance
The tighter financial conditions associated with US dollar strength can create headwinds for global equity markets, but there are relative winners and losers. Increased debt servicing cost for non-US governments and corporations that have borrowed in US dollars has tended to weigh on the performance of emerging market equities during periods of US dollar strength. As the US dollar has strengthened, there has been a tendency for emerging market equities to underperform their developed market counterparts.
However, Morgan Stanley note that this inverse relationship has lessened somewhat of late, potentially as a result of the change of sectoral composition of emerging market equities along with improved balance sheets and a reduced reliance on dollar borrowing as local bond issuance has increased in recent years13.
Companies listed in the US can also suffer the effect of a strong US dollar, not least as corporations with large operations abroad see the US dollar value of their overseas sales reduced. Some 40% of the revenues of the 500 companies which make up the main US stock market index are generated overseas.
However, the proportion varies dramatically across sectors, with the information technology sector (which includes the likes of Apple and Microsoft) earning nearly 60% of revenues abroad, while the figure for the utilities sector is just 2%14. Unsurprisingly, the shares of US companies that are more dependent on overseas revenues have performed more poorly than their domestically-focused counterparts this year, falling15 23% and 11% respectively16.
In contrast, the strength of the US dollar (and weakness of Sterling) has been supportive of the UK’s main equity market in recent months. The UK’s main index of 100 leading companies is one of the few markets to post a positive local-currency gain this year, albeit marginal at around 1%17. This is because around three-quarters of the revenues of the UK’s largest 100 listed companies originate from overseas, with the result that when the dollar appreciates, overseas earnings are worth more when converted back into sterling (see our commentary of June 2022). While the strength of the US dollar undoubtedly poses challenges for the global economy, investors in UK large caps have at least seen some benefit.
20th September 2022
1 https://www.theguardian.com/business/2022/sep/05/uk-facing-1970s-style-balance-of-payments-crisis-under-liz-truss
2 https://tradingeconomics.com/euro-area/currency
3 https://tradingeconomics.com/japan/currency
4 https://www.marketwatch.com/investing/index/dxy
5 https://www.eia.gov/energyexplained/us-energy-facts/imports-and-exports.php#:~:text=The%20United%20States%20became%20a,the%20largest%20margin%20on%20record.
6 https://www.statista.com/statistics/673333/monthly-prices-for-natural-gas-in-the-united-states-and-europe/
7 https://www.reuters.com/markets/us/dollars-historic-surge-may-be-music-feds-ears-mcgeever-2022-08-24/
8 https://www.exchangerates.org.uk/commodities/BRT-GBP-history.html
9 https://www.imf.org/en/Publications/WP/Issues/2020/07/17/Patterns-in-Invoicing-Currency-in-Global-Trade-49574
10 https://www.theguardian.com/business/2022/sep/08/ecb-european-central-bank-interest-rates-eurozone
11https://www.poundsterlinglive.com/gbp-live-today/17528-pound-to-euro-and-dollar-100bp-bank-of-england-hike-needed
12 https://www.fsb.org/wp-content/uploads/P260422.pdf
13 https://scholar.harvard.edu/files/christopherbaxter/files/07.27.2022_-_emerging_markets_are_less_sensitive_to_dollar_strength_than_you_might_think.pdf
14https://advantage.factset.com/hubfs/Website/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_091622A.pdf
15 https://www.spglobal.com/spdji/en/indices/equity/sp-500-foreign-revenue-exposure-index/#overview
16 https://www.spglobal.com/spdji/en/indices/equity/sp-500-us-revenue-exposure-index/#overview
17 FE Analytics