The Impact of the Strengthening Dollar
The United States dollar has now reached a four-month high. This high can be attributed to the fact that the Fed has announced that the interest rate hikes will increase in the year 2018. This means that American investors have the opportunity to earn higher interest on their investments at home. As a result, investors are liquidating investments made in other currencies and are moving money back home. This has led to an increased demand for the dollar which has been the underlying cause of this strengthening. The interest rate hike and the strengthening dollar are both moving in a recursive fashion. This means that one is giving rise to the other causing a spiral effect.
However, since the dollar is a currency that is used worldwide for several transactions, the strengthening is bound to have a tremendous impact. In this article, the effect has been listed and explained.
Effect on the United States Stock Markets
Rising interest rates are always bad news for the stock market. This is because as the interest rates increase, so does the cost of borrowing. Hence, the profits of the company are lowered. Also, since risk-free investments start giving better returns, investors become averse to equity. Finally, United States has several multinational corporations. A lot of these corporations earn a majority of their revenue overseas. If the dollar strengthens, then these companies record exchange rate losses, and their income is reduced. Along with the factors already mentioned above, this creates a significant adverse impact on the equity markets. The suggestions made by empirical evidence are also the same. Barring a few sectors like real estate and telecom, most American corporations witness a fall in their market capitalization if the dollar strengthens. Hence, it is advisable for equity investors to juggle their portfolio so that they are not caught off guard when the dollar starts increasing in value.
Effect on the United States Economy
A strong dollar may not be suitable for the stock market. However, it is definitely good for the economy in general. This is because a stronger dollar means that imports get cheaper whereas exports become more expensive. The American economy is not dependent upon exports. America exports only about 12% of its GDP. This can be compared with rough 50% which is the share of exports in Chinas GDP. Exports form more than 25% of the GDP of other G-7 countries as well.
Hence, the strengthening dollar is proving to be a leveler. It will help America to dent the economic progress of other countries without hampering their own. Also, a strengthening dollar means that more American corporations move their money back home. This reduces the need for imported capital which diminishes current account deficit.
Effects on American Bonds
American bonds may be the biggest beneficiary of the strengthening dollar. This is because a strengthening dollar increases the yields of treasury bonds in real terms even if the nominal rate remains unchanged. This is the reason why investors start preferring American bonds over bonds issues by other developed nations. This helps the American economy because they can borrow money at better interest rates. This reduces the cost of borrowing and ultimately reduces the fiscal burden on the government and the entire economy.
Effect on Emerging Markets
Emerging markets are probably the worst hit as a result of the strengthening dollar. This is because of the following reasons.
Firstly, investors start pulling money out of emerging markets and send them back to the United States once the dollar strengthens. Hence, the market capitalization of entire equity markets is reduced.
Secondly, all essential commodities are priced in dollars. Hence, when the dollar strengthens, the price of essential commodities like gold and oil also increase in foreign currency terms. Emerging market economies have to import these commodities. Since the dollar has strengthened, the price increases in local currency terms even if the price is stagnant in dollar terms.
Thirdly a lot of emerging market economies have high amounts of external debt. They have to pay interest payments on this debt. The debt, as well as the interest, is denominated in terms of the dollar. This means that when the dollar strengthens, the interest payments become more expensive in local currency terms. This leads to increasing fiscal deficit which is then corrected either by printing more money or by borrowing more. Both the situations are detrimental to the health of emerging market economies in the long run. Most of the external debt is not paid back. It is simply rolled over on maturity. However, when the dollar strengthens, rolling over of debt also becomes very difficult.
To sum it up, a strengthening dollar could mean different things to different stakeholders. Some are likely to gain, and some are likely to lose. However, it is important to realize that the strengthening of the dollar is not a short-term trend. Instead, the stronger dollar is here to stay. There have been two bull runs for the dollar prior to this, and both have lasted approximately six years. Hence, it is essential to consider the impact of the dollar on investments before taking positions.
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.