December 15, 2022 | 5 Minute Read
Global Head of Strategic Advisory Solutions
Senior Market Strategist, Strategic Advisory Solutions
For more than a decade, markets have been buoyed by cheap credit and a steady stream of fiscal stimulus that became even more pronounced when the pandemic hit. But with inflation now running at multi-decade highs, fiscal and monetary policymakers have reversed gears, leaving the global economy in a weakened state. One thing has not changed, however: the US dollar remains the world’s reserve currency, which is likely to keep financial conditions tight and weigh on the outlook for global growth—and many individual economies—for some time.
Having appreciated sharply since the Federal Reserve (Fed) began raising interest rates this year to counter inflation, the dollar is now pushing global policymakers in some countries to intervene in foreign exchange markets to prop up their own currencies, whose declines have compromised their own inflation-fighting efforts. In others, including the UK and the euro area, the dollar’s rise is forcing central bankers to raise interest rates at a time when their economies are already in or near recession. For these policymakers and many other financial institutions around the world with dollar holdings, the US currency remains what John Connally, a former US Treasury Secretary, said it was more than half a century ago: “The dollar is our currency, but it is your problem.”
With consumer prices rising substantially from their low pre-pandemic levels, global central banks have embarked on their most hawkish tightening campaigns since the 1980s. But each country has its own set of circumstances when dealing with inflation, and the US in particular benefits from having a moderately closed economy and relative insulation from the ongoing energy crisis in the euro area and the UK. The Fed, therefore, has been able to raise rates even faster than its global counterparts. We expect that varying regional inflation rates, diverging central bank policy decisions, and different regional COVID-19 conditions will continue to drive currency volatility.
The US dollar’s surge in the past year has taken it to multi-decade highs, but there has been a pullback through the end of 2022. The recent sharp drop in the pound’s value following a September government mini-budget that featured unfunded tax cuts is the most notable example. As a result, global policy makers have had to respond with interventions not seen in decades. Additional expected rate hikes from the Fed suggest the dollar is not likely to weaken in the short run as investors around the world continue to turn to the US currency as a safe haven. That status has its roots in the 1944 Bretton Woods agreement, when the dollar was pegged to gold and, in turn, 44 nations pegged their currencies to the dollar. This relationship made US currency the reserve currency of the world–a status that survived the fixed exchange rates collapse in the 70s, globalization, and the rise of technology. There are a few simple reasons for this: countries continue to hold dollars in their currency reserves, the US currency still provides unmatched stability and liquidity, and dollars and dollar-backed securities are backed by the US Treasury.
Source: World Bank and Goldman Sachs Asset Management. As of October 31, 2022. Map shows amount of US dollars and US dollar-backed assets, in billions, held by different countries around the world.
Central banks around the world still understand the dollar’s role in the global economy. Consumers and producers, however, do not have the war chests that central banks do, making it much harder for them to manage their currency risk, a reality that has been recently highlighted by the United Nations, International Monetary Fund and the World Bank.
Consider a US company with global sales, whose non-US consumer base purchasing power has experienced a 15% decline. On an index level, the S&P 500 generates 29% of revenues outside of the US, and estimates show that a 10% appreciation in the dollar reduces index level earnings by roughly 2.5%.1 This helps to explain why a rise in the dollar can trigger a corresponding decline in equities (and other so-called “risk assets”). And since oil and many other commodities are denominated in US dollars, a strong dollar can cause a decline in commodity prices. From a US macro standpoint, a strong currency typically means fewer US exports, which in turn has a negative impact on gross domestic product (GDP). On the flip side, a strong dollar has a downward impact on import prices, which can act as an aid in the fight against inflation. This downward impact on inflation may explain why the Fed has kept quiet about dollar strength despite pleas from organizations such as the UN to stop raising rates. We don’t expect Fed policy to change until inflation in the US is under control.
The dollar is at two-decade highs, but just because something is expensive relative to history doesn’t mean that it can’t rise further in the right environment. So, what might it take for the dollar to cool off?
First, the US growth outlook would likely have to deteriorate even further than it has. We believe the UK is already in a recession, and the euro area is headed toward one. Growth in Japan has also surprised to the downside. By contrast, US growth momentum remains relatively strong, and the economy may avoid a recession altogether. The dollar’s appreciation may start to slow if economic data in the year ahead begins to show a sustained slowdown in US inflation.
Second, the Fed would have to slow down its pace of hiking and reach a terminal rate. At the same time, other central banks would have to continue raising interest rates. While nearly all major central banks have tightened policy stances, the Fed has generally raised interest rates by a greater magnitude than its global counterparts. These frontloaded rate hikes, in turn, have put pushed up the dollar’s value. We expect such a trend to continue over the next few months as the European Central Bank and Bank of England will likely take more time to catch up to the Fed given their respective deteriorating growth outlooks.
Source: Macrobond, Federal Reserve Bank of St. Louis, and Goldman Sachs Asset Management. As of November 6, 2022. Latest is October 2022. Interest rate differential calculated using the historical weights of Nominal Advanced Foreign Economies U.S. Dollar Index published here. Past performance does not guarantee future results, which may vary.
The main scenario in which the dollar could weaken in the short term would be one of coordinated intervention by central banks. This is what happened in the 1985 Plaza Accord, when G10 central banks, including the Fed, agreed to take coordinated action to weaken the dollar and strengthen the yen and European currencies. The move was prompted by a prolonged period of dollar strength that was partly fueled by the Reagan Administration’s tax cuts and Fed rate hikes to combat inflation.
There is one key difference between today’s conditions and those that prevailed in the 1980s, though. Back then, the US wanted a weaker dollar. As the US trade deficit grew, policymakers worried that the strong dollar was dulling the country’s competitive edge. But today, the dollar’s strength is helping temper inflation, so it is not in US policymakers’ interest to stop the currency’s rise.
In the absence of any similar accord to slow it down, the dollar is likely to keep rising at least until the second half of 2023 when the Fed may shift its focus from inflation control to growth concerns. In these conditions, the euro, pound and yen could start to recoup some lost ground in the currency game.
As long as the US currency is rising, investors may benefit from additional returns when choosing not to hedge their exposure to US assets. But the decision to hedge or not to hedge is always a nuanced one.
Historically, the decision to invest internationally has had a greater impact on portfolios than the decision to hedge. We find that as investors increase their time horizons, the short-term currency hedging effects dissipate.
Source: Bloomberg, Goldman Sachs Asset Management. As of October 31, 2022. Chart shows MSCI EAFE absolute, monthly returns in USD to simulate an unhedged currency portfolio, and MSCI EAFE absolute, monthly returns in local currencies to simulate a hedged currency portfolio. Past performance does not guarantee future results, which may vary.
Hedging may make sense for investors with high-conviction currency views or underexposure to dollar-denominated assets. For instance, investors with a strong belief that the dollar will rise may want to replace foreign currencies with dollars. In many cases, however, investors may have limited conviction in their currency views. Many investors also tend to have a “home country bias” in their investments, depending on hedging costs; non-US investors that meet this profile might be reluctant to diversify beyond their home currencies—euro, yen, etc.—with excessive dollar exposure. There’s an upside to this approach as well: leaving euro, yen or other foreign currency exposure within an international equity investment potentially adds to portfolio diversification.
Still, concerns over the risk of de-dollarization—reducing a country’s reliance on the US dollar—remain. Over-reliance on a single producer or source of goods may be a problem; Russian natural gas has underscored this phenomenon clearly, and even the US has passed legislation like the Creating Helpful Incentives to Produce Semiconductors and Science Act of 2022 (CHIPS Act) to strengthen manufacturing, supply chains and security. Skeptics worry about US debt sustainability, the use of the dollar to advance foreign policy objectives, and other currencies overtaking the dollar’s reserve currency status. But how viable are these worries?
Some threats of de-dollarization are hard to ignore—Saudi Arabia’s proposal to accept renminbi instead of dollars for Chinese oil sales is a prime example. But most of the efforts appear symbolic, ineffective, or both. The US dollar has persisted as the world’s reserve currency for decades, with roughly 50% of international trade invoiced in dollars and involvement in almost 90% of all FX transactions. While we acknowledge that the case to diversify away from the dollar may be stronger today than it was just a few years ago, we still think there’s a low probability that another currency, basket of currencies, or substitute asset would become strong enough to dethrone the dollar. A strong dollar does create challenges, especially for US exporters and countries that must service dollar-denominated debt amid aggressive monetary policy tightening and a weak economic growth outlook.
What remains clear is that the current global economic environment was a central cause for this historic rise in the dollar’s value. But the lasting effects will be a key theme to watch in the years to come.
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