Why A Strong Dollar Is Not As Good As You Think

To most people, a strong currency means a strong country. Weak countries have weak currencies. Strong dollar…U.S. strong like bull.

But that’s Tarzan-level thinking. The leading proponents of a strong dollar are the big investment firms of Wall Street who work as asset managers or broker/dealers for foreigners. A strong dollar means more investors are buying U.S.-denominated securities – namely Treasury bonds or plain old cash.

In that sense, a strong dollar leads to the hyper-financialization of the U.S. economy. It is best to call it an overvalued dollar, as the dollar will always be strong even if the dollar index is trading slightly under 100.

When financial securities become the only business in town, it becomes a detriment to most other sectors of the economy. This is especially true for exporters and manufacturers who compete with companies abroad making the same thing. A Boeing 737 Max now costs more than the Airbus 320neo for airlines worldwide.

In an economy where companies are experiencing tighter margins due to inflation and less demand, a stronger dollar makes it is easier for them to source goods abroad, potentially putting their local suppliers out of business. If they are manufacturers themselves, they will outsource that work to Mexico or Asia, leading to layoffs and wage stagnation at home.

“The strong dollar has hurt several multinational companies in terms of less competitive pricing and foreign exchange losses of unhedged sales in foreign currency,” says Eric Merlis, Managing Director & co-head of global markets at Citizens. “This has reduced or put a damper on equity price gains.”

Principal Asset Management’s senior global strategist Seema Shah told the New York TimesNYT
on Thursday that current interest rate policy at the Federal Reserve “is supercharging the U.S. dollar, limiting the ability of other global central banks to manage their economies adequately.”

Higher rates mean higher bond yields and fixed-income investors like that. They buy Treasury bonds, among other things. The Times article eluded to the Fed trying to convince the European Central Bank (ECB), Bank of England and the Bank of Japan to raise their interest rates in line with the U.S. in order to get their big investment firms to stop pouring money into the dollar.

“Interest rates in Europe and Japan have a very important domestic function and an international function. But you cannot have international needs take precedence over domestic needs,” says Jeff Ferry, chief economist with DC-based think tank Coalition for a Prosperous America. “If the ECB raises interest rates to match ours, they will cause an even worse recession, and businesses already have their backs against the wall because of energy costs. I think the dollar should come down by a good 20% to 30%,” Ferry says.

Sebastien Galy, senior macro strategist at Nordea Asset Management, agreed that the U.S. is putting pressure on Japan and the ECB to raise interest rates. “The next leg of this might happen in Japan,” he says, citing threats from Washington to withhold some F-15 fighter planes to Japan.

Dollar Index, Highest in 20 Years

The dollar index is trading at around 111, its highest rate since 2002.

Why is it so strong? One reason is that the dollar is the main reserve currency held by central banks worldwide. When you have a weaker global economic outlook, big investors want to hold stable, high-quality, fixed income. The biggest market for that is the U.S. The other reason is the Fed raising rates, making Treasury bond yields attractive to investors abroad.

“We could be here for a while…until core central banks catch up to the Fed,” says Roger Aliaga Diaz, a chief economist for Vanguard.

To people in government and some influential investment banks that do business with Europe and Japan daily, the dollar should be free to be as strong or weak as investors want.

But the market is more than Treasury Secretaries and BlackRockBLK
. Many on the Street, and in investment houses nationwide will say in private that the dollar should not just go where it wants to go all the time.

We have been here before.

The dollar was even stronger in 1985. The dollar index hit 170 then. It was like there was no other currency in the world. Ronald Reagan, who loved free markets, did the Plaza Accord to bring the dollar to a manageable level.

Brazil: An Example in Currency Management

In 2009, Brazil’s Finance Minister Guido Mantega said the U.S. and Europe were waging a “currency war” against developed countries by reducing interest rates to zero. No one wanted to hold dollar fixed income. It had less and less yield. American and Europeans piled into high-yield, deeply traded markets. Brazil was one of them. The Brazilian real hit a high of 1.50 to the dollar, even though the economy was still reeling from the Great Recession. So Mantega put a tax on all foreign investors buying Brazilian bonds. Wall Street fund managers complained. But the long-term guys stuck around. Brazil didn’t suddenly go broke. And the Brazilian real started to weaken, making Brazil’s exports competitive again.

“The market learned in Brazil something about risk management then,” says Galy. “You can’t drive a country up against the wall with an overvalued currency without (eventually) a reaction from the authorities.”

The U.S. authorities, however, are okay with a strong dollar. There is no talk of managing it to a more bearable level. And the Fed is not pivoting away from rate hikes anytime soon.

“It would be best to manage the dollar in a way that would be flexible by installing a market access charge against foreign investors,” says Ferry. “That would allow the Fed to lower the dollar over some time and not allow it to skyrocket by 20% as it has over the last several months. You wouldn’t have to use it all the time, but if you had a market access charge of 2% to 3% per transaction on U.S. securities from abroad, it would bring the dollar to a more sane level,” Ferry thinks. “The money goes to Treasury. You would use it to pay down the federal debt.”

Like Brazil’s fee that weakened its currency in 2009-10, a market access charge would mean a Japanese investment house that wants to buy a $100 Treasury bond would have to pay $3 if the fee was 3%, meaning their $100 bond would cost them $103. Long-termers might be okay with that. Short-term traders would think twice. For proponents of the Brazil approach, a market access charge is a temporary way to curb dollar enthusiasm in moments like these.

Treasury and the Fed have not hinted at anything like a new Plaza Accord agreement. Earlier this month, the Financial Times warned Washington not to even think about it in a not-so-subtle headline: “Forget about a new Plaza Accord.”

Stronger Dollar. Weaker Countries.

An overvalued dollar is also bad for emerging market countries.

“They face headwinds because of dollar debts,” says Merlis from Citizens. “Markets are not pricing in emerging market defaults yet, but this is something to keep an eye on if the dollar continues to strengthen.”

Countries like Egypt and Pakistan are struggling with dollar-denominated foreign debts. Exports generate dollars for emerging markets, but these countries need that revenue to buy commodities they don’t produce at home – like oil and gas, grains and minerals.

A strong dollar is bad news for weaker countries. It makes them even weaker.

One thing is not being able to pay the Paris Club. It’s another not being able to import wheat and oil. That can lead to “storm the Bastille” moments in countries in the grips of a falling economy, no food and no fuel.

These, of course, are worse-case scenarios exacerbated by a strong dollar compared to countries with already weak and undervalued currencies. However, a strong dollar could be managed in times like these to better avoid such crises without harming financial markets.

Of course, everyone knows that a strong dollar means the U.S. consumer can afford cheaper items from abroad. Yet, this comes with a price. They have to buy cheaper items from abroad because their industrial base continues to whither away in favor of imports. And their old manufacturing incomes have given way to Macy’s retail and W Hotel doorman-level income instead.

“The financial industry loves a strong dollar because it makes it easy to sell what they have on their shelves – securities priced in dollars,” says Ferry. “With so much international trade in manufactured goods and agriculture, every American producer in a strong dollar environment sees their goods costing more on world markets while foreign competitors are less expensive. You lose market share that way, too,” Ferry says. “The dollar is overvalued. We all know it. It’s bad for mostly everybody except those who sell financial securities.”