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America has lost the overwhelming economic lead it enjoyed in the aftermath of the Second World War, but it still has the world’s pre-eminent currency. The dollar constitutes over 60 per cent of official foreign exchange reserves; is used extensively in global trade, notably in commodities such as oil; and is especially favoured by borrowers outside the US raising funds in a foreign currency. Any sustained move in the dollar has implications for investing strategies.

In troubled times, the dollar typically strengthens as investors seek a haven. That happened when the global financial crisis came to a head in the autumn of 2008. It occurred again this spring when markets panicked over the potential economic damage arising from the pandemic.

But that jump in the dollar in March proved as short-lived as the leap of a March hare, certainly measured against the currencies of other advanced economies such as the euro and the pound. Since that peak it has been on a downward trajectory, falling by around a tenth by early autumn. (The dollar also lost ground over the same period against the currencies of emerging economies. But with the important exception of China, it was still higher in early September than at the start of 2020, whereas it was lower against advanced trading partners.)

At first sight, a falling dollar should boost the US economy by making its exports more competitive and profitable. Conversely, countries whose exchange rates strengthen against the dollar might be expected to suffer. In practice, the general easing in financial conditions around the world that accompanies a weakening dollar tends to trump these direct economic effects. As Claudio Borio of the Bank for International Settlements (BIS), a hub for central banks, said in a lecture last year, “A weaker US dollar coincides with upswings in the global financial cycle.”

Such an upswing, which is driven mainly by advanced economies, typically starts with the US central bank easing monetary policy. The Federal Reserve did that big time this spring, slashing short-term interest rates and buying bonds to bring down long-term yields. That made it less attractive for international investors to park funds in American markets, pushing down the dollar. In a further significant step this summer, the Fed modified its fixed 2 per cent inflation target, instead aiming for that as an average over time. Given what its chair Jerome Powell called “the persistent undershoot of inflation,” that sent a signal that US monetary policy will now remain looser for longer.

Where the Fed leads, other central banks follow, especially as they seek to restore national competitiveness by containing the rise of their currencies against the dollar. As its decline has continued, the pressure has mounted for even more easing, especially on the part of the European Central Bank, which has tended to rely on a cheap currency to buoy the eurozone. A weaker dollar also contributes to looser conditions through what the BIS calls “the financial channel of the exchange rate,” as firms outside the US find it easier to service their debt in dollars and borrow more.

If the trend of a weakening dollar is sustained, the link with an upswing in the global financial cycle bolsters the argument for acquiring riskier assets, especially equities. Although sterling has weakened again this autumn owing to renewed tensions between the UK and the EU, there is a strong case for directing such investment into international funds that focus on the main advanced economies outside Britain. Their stock markets should benefit from the general loosening in financial conditions while offering a more stable political environment for investment.

Original Link:

https://www.prospectmagazine.co.uk/magazine/what-investors-need-to-know-when-the-dollar-falls

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