The Perspective Blog
The Strong US Dollar and What it Means for Us
Since the start of 2022, the US dollar has been a top performer among global currencies and has reached a 40-year high when compared against a basket of global currencies1. Investors treat the US dollar as a safe haven in times of uncertainty, and the combination of Covid-19, the Russian invasion of Ukraine, and high inflation have driven investors to seek shelter in US dollars.
The rise of the US dollar means a decline in US dollar purchasing power elsewhere, We have certainly felt the pain of that here in Canada, but it’s worth noting that the Canadian dollar has also been among the top performing global currencies for the year. The decline against the US dollar is less a story of Canadian dollar weakness and more a story of outright American dollar strength. For example, from the beginning of the year to October 27th the Canadian dollar had declined 6.9% against the US dollar. But over the same period, the Euro declined by 10.9% and the Japanese Yen declined by 21.0%.
As Canadians, we are accustomed to our currency performing well when oil prices are high. While that has proven true against most currencies, it has not held against the US dollar in 2022. This can be partially explained by the fact that over the last 20 years, the US has become a net exporter of fossil fuels and no longer faces currency weakness in times of high oil prices.
The relative increase in the value of the US dollar can also be partially explained by the US Federal Reserve’s hawkish policy activity. They were among the first central banks to raise their overnight lending rate and have continued to raise early and often compared to the rest of the world, including the European Central Bank and the Bank of Japan.
When the global reserve currency experiences such a drastic increase in value in a short period of time, there can be some major dislocations in the global economy. The longer the strength lasts, the more pronounced these effects are likely to become. So what effects have we seen during past periods of US dollar dominance?
First, import prices tend to rise internationally. The US dollar is used worldwide as the global currency for invoicing. When the US dollar is strong, imports become more expensive in local currency terms for international buyers, which leads to a decrease in demand for imports. As a result, the World Trade Organization is forecasting a slowdown in world trade growth in 20232.
Second, we tend to see an overall tightening effect on global growth due to balance sheet constraints. Many international companies hold US dollar debt on their balance sheets. As the value of the US dollar increases, this debt becomes more expensive in local currency terms. Combine that currency effect with higher interest rates, and we expect companies to have a lower risk appetite and to face constraints on their ability to borrow additional funds to make large new investments.
Third, we can expect intense pressure on the Bank of Canada to continue raising their overnight rate in line with the US Federal Reserve. Think about this from the perspective of an international investor: if you have a choice between holding US short-term deposits yielding 4% or Canadian short-term deposits yielding 3%, why would you hold the Canadian deposits? So if the Bank of Canada chooses not to raise their overnight rate, international investors will sell their Canadian dollar holdings and buy US dollar holdings, bidding up demand for US dollars and driving down demand for Canadian dollars. The Bank of Canada may reach a point where they have raised their overnight rate enough to tame domestic inflation and economic activity, but if the Federal Reserve continues to increase rates, the Bank of Canada will feel pressure to keep up to preserve the value of the Canadian dollar.
Lastly, and on a more positive note, the strong US dollar means that declines in the value of US assets appear less extreme when reported in Canadian dollars. For example, to October 27th, the S&P 500 had declined 20.1% in US dollar terms, but only 13.4% in Canadian dollar terms. This is a common outcome because the US dollar is typically a strong performer during stock market declines.– Canadians tend to see a dampening effect on the volatility of their portfolio. During downturns, we see smaller decreases in Canadian dollar terms and during strong markets, we see smaller increases in Canadian dollar terms.