VOLATILITY AND THE VALUE OFTHE U.S. DOLLAR
April 12, 2023
Recent volatility in the value of the U.S. dollar is causing concern for some investors. In this report, The Mather Group LLC (TMG) reviews potential factors that may be driving the dollar’s recent volatility, how this volatility might affect sectors of the U.S. economy, and what the outlook could be for the U.S. currency.
To assess the true value of the dollar, rather than tracking it against individual currencies, a useful method is to monitor the Broad U.S. Dollar Index prepared by the Federal Reserve Board (Fed). Its composition includes the 26 largest trading partners of the U.S., with each country’s currency weighting in the index determined by its dollar volume of trade in goods and services. Overall, this index represents 90% of bilateral trade with the U.S.
As shown in the graphic below, this index reached its 10-year peak on September 27, 2022, but subsequently fell by 6.6% as of March 31, 2023. Whether this downward trend might continue is now a concern for corporations, investors, and the U.S. government. At the same time, it’s worth noting that dollar volatility is not uncommon, as during the 10-year period shown, the dollar hit five new highs and five new lows in its relative value.
Volatility Sources
There are two primary drivers of historic and recent dollar volatility. One has been interest-rate decisions made by the Fed, either to spur the economy’s recovery after the Great Recession, or, more recently, to tamp down rising levels of inflation. A second driver of changes in the U.S. dollar’s relative value has been the growing strength and outlook for the U.S. economy.
While the Fed’s decisions focus primarily upon the U.S. economy, the response is indeed a global one. More specifically, before the nine recent Fed Funds Rate hikes, there were significant inflows of foreign funds to purchase Treasury bonds and other dollar-denominated assets, as U.S. securities offered higher yields than those of other nations. To purchase dollar-denominated securities, foreign investors must exchange their currency for dollars, helping to drive the relative value of the dollar upward.
As shown in the graphic below, the historic yield differential between 90-day Treasury bills and 90-day German Interbank rates began to diverge in May 2015 when German rates went negative. The resultant gap in yields was largest in March 2019, when Treasury bills were yielding 2.40% compared to Germany’s yield of -0.31%, for a yield differential of 2.71%. German rates finally turned positive in July 2022 after 86 months at negative levels, while the Fed Funds Rate remained positive throughout that period.
For another perspective, let’s evaluate how the Fed Funds Rate has interacted with the Broad U.S. Dollar Index. As shown in the graphic below, the index (shown in red) broadly tracks major movements in the Fed Funds Rate (shown in blue). While the relationship might not appear highly correlated, it is notable that, when the Fed cut rates significantly at the outbreak of the COVID pandemic, the index fell (as it did in 2008 when the Global Financial Crisis began). However, when the Fed reversed course and raised rates in 2022 as a response to inflationary fears, the dollar soared to its recent 10-year high.
When compared to other national economies, the U.S. has shown far higher growth levels, even before the COVID pandemic struck. A stark example of the U.S. economy’s relative strength is a comparison of U.S. inflation-adjusted gross domestic product (GDP) to that of Germany. Germany is the largest economy among the 27 nations comprising the European Union (EU), with its GDP contributing 25% to the EU’s combined GDP.
As shown in the graphic below, Germany’s economy grew in parallel with that of the U.S. from 2013 until 2017, but then fell behind the U.S. This gap has only increased since the COVID pandemic. Most analysts concur that the significant size, profitability, and growth rate of the U.S. technology sector has driven this disparity.
Foreign investors recognized the U.S. economy’s greater growth levels, so their funds flowed increasingly into U.S. equity and fixed-income markets. To invest in the U.S. economy, those investors had to buy U.S. dollars, again raising its relative value.
Weaker Dollar and the Economy
If the dollar were to continue its recent downward trend, it might impact some sectors of the U.S. economy, but some impacts will be positive. A weaker dollar, for example, means that when U.S. corporations report their foreign profits, those profits are higher when converted to dollars. This is a significant issue, as 40% of total earnings for companies comprising the S&P 500 come from foreign sales. For the technology sector, 58% of total earnings come from foreign sales.
A weaker dollar also means that manufacturing companies using imported raw materials might find their costs rising. If these costs cannot be passed through to customers, profit margins might fall. An example of this challenge is imported metals such as cobalt, lithium, and nickel used in electric vehicle batteries. Battery packs now represent 40% of the total cost of an electric vehicle, and, while technology might lower future manufacturing costs, little can be done to reduce the price of imported metals if the dollar weakens further. As there continues to be significant domestic resistance to mining these metals in the U.S., metal imports might have to continue.
The future pricing of fossil fuels might change due to a potentially weaker dollar amid rising geopolitical tensions. The dollar has been the de facto mechanism for oil pricing and trading since 1974, becoming the so-called “petrodollar.” However, Russia, as the second-largest exporter of oil behind Saudi Arabia, remains sanctioned and is reported to price and accept payments in Russian rubles, Indian rupees, United Arab Emirates dirhams, and Chinese yuan. Further, with China purchasing 26% of Saudi Arabia’s oil exports, Reuters reported that it is asking Saudi Arabia and other Gulf exporters to consider accepting payment—not pricing—in yuan.
Any shift away from pricing and payment in dollars might reduce demand for the U.S. currency. In addition, major exporters like Saudi Arabia have long recycled their excess petrodollars by purchasing U.S. Treasury bonds. Given the need for these bond sales to offset the U.S. government’s growing budget deficit, a reduction in foreign sales might drive Treasury yields higher. As other fixed-income products, such as home mortgages and car loans, are linked to government bond yields, higher rates might impact future consumer spending levels.
The Dollar Outlook
The Fed’s outlook on the U.S. economy drives its interest-rate decisions, and its current focus on inflation suggests further rate increases might occur until there is evidence of slowing inflation. However, the prior linkage between Fed Funds Rates and the stronger dollar might begin to loosen, as other central banks have been raising their rates to combat similar bouts of inflation.
For example, the 10-year Treasury bond is yielding 3.30%, while the UK 10-year bond is yielding 3.42%, and Germany’s 10-year bond yields 2.18%. Hence, the flow of international funds into U.S. fixed-income and equity securities might wane and result in lower dollar demand. More specifically, the U.S. Treasury reported that foreign holdings of U.S. securities fell by 7% from 2021 to 2022. If the Fed were to end its rate hikes or reduce them in the face of a potential U.S. recession, then its former yield advantage might decline.
With respect to the outlook for economic growth, the International Monetary Fund projects that global 2024 GDP growth will be 3.1% on an inflation-adjusted basis, rising from the 2.9% forecast for 2023. In contrast, the U.S. is projected to achieve inflation-adjusted GDP growth of 1.0% in 2024, falling from its 1.4% forecast for 2023.
This projected decline in U.S. GDP is based on the prospect of a recession that may be spurred by ongoing Fed rate hikes, increased fears about the liquidity and solvency of U.S. banks, and lackluster consumer sentiment. Consumer sentiment is the primary driver of consumer spending, which comprises 70% of U.S. GDP, and, while slowly recovering from pandemic levels, consumer sentiment remains 29% below its April 2021 peak.
However, all is not gloomy with respect to the outlook for the dollar. Both regulators and legislators are addressing recent bank stress, shoring up confidence in this vital sector of the U.S. economy. As a result, foreign purchases of U.S. financial assets might soon return to their former levels.
If the geopolitical crisis in Eastern Europe were to end, or at least stabilize, then the significant disruption in world trade might diminish, benefiting both U.S. corporations and consumers. When inflation begins to subside—and it will—the Fed will reverse its hikes to allow credit conditions to become more expansionary. Corporate profit margins will be less pressured as rates begin to decline, potentially drawing further foreign investment.
Of course, a weaker dollar means that international travelers might be more inclined to visit the U.S. Thus, a key source of potential dollar strength is the rapidly rising number of tourists. As shown in the graphic below, foreign tourism is rebounding strongly with 52 million visitors in 2022, up from 19 million in 2020. This level is projected to reach 63 million in 2023 and exceed its 2019 peak of 79 million by 2025. At its pre-COVID peak, international travelers spent $240 billion and directly supported one million U.S. jobs.
As importantly, the U.S. economy remains highly resistant to the energy crises gripping so many other nations, and it has gained both foreign corporate and government energy customers on a long-term basis. As shown in the graphic below, liquid natural gas (LNG) exports from the U.S. to Europe resulted in $35 billion of LNG export revenues during the first nine months of 2022—all paid in dollars. So, the LNG export economy will likely continue its growth and support for the dollar.
While the dollar might appear volatile, TMG remains disciplined in employing its risk management tools and its portfolio diversification strategies. This diversification includes not only different asset classes and industrial sectors, but also geographic diversity—and international equities have historically outperformed U.S. stocks during periods of dollar weakness. As importantly, clients who continue to adhere to their financial plan will maintain the strongest pathway through this uncertain period. Your trusted advisor at TMG is ready to respond to any questions or concerns which you might have, and to help ensure that your financial plan remains both timely and actionable. Please reach out to your advisor for guidance at any time.
Sources: Bloomberg; Conference Board; Congressional Budget Office; Federal Reserve Bank of St. Louis; Federal Reserve Board of Governors; International Energy Agency; International Monetary Fund; Reuters; National Travel and Tourism Office; Rocky Mountain Institute; Statista; University of Michigan Consumer Sentiment Index; U.S. Energy Information Agency; U.S. Treasury; Wall Street Journal
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