Why a strong dollar hurts – and what you can do about it

Last week, the US dollar hit its highest level in nearly 20 years by a popular measure. The US Dollar Index examines the value of the US dollar against a basket of six other major currencies. The euro has by far the heaviest weight at more than half of the basket, with the rest comprising (in order of size) the Japanese yen, the pound, the Canadian dollar, the Swedish krona and the Swiss franc. The index started in 1973, just after the United States left the gold standard, with a value of 100. It’s had a lot of ups and downs since then – it hit an all-time low in 2008, just above 70, while its high came in 1984, near 165.

It’s now around 106. That may not sound dramatic, but it’s the highest since November 2002, and the move has been rapid – the dollar is up almost 10% against the euro this alone. year, and an extraordinary nearly 20% against the yen. Why is this important? The dollar is the world’s reserve currency; it dominates global trade and central banks around the world have it at the heart of their reserves. Simply put, everyone needs dollars. So when the price of a dollar rises relative to everything else – as it is right now – it effectively means that liquidity is tightening around the world, not just in the United States. This is at least one of the reasons why markets everywhere are in trouble.

Why is the dollar so strong?

Given that most countries are now raising interest rates and tightening monetary policy (which usually results in stronger currencies), why has the dollar gotten so far ahead? Its strength has a fairly simple explanation, according to liquidity expert CrossBorder Capital: the US is tightening monetary policy more aggressively than anyone else – the Federal Reserve’s ‘quantitative tightening’ is ‘outpacing all other major central banks’ . On top of that, you have a feedback loop where a stronger dollar hurts risky assets, which scares off investors, who then run for the perceived safety of the dollar, driving it higher still.

What does this mean for your money? There’s no point in trying to time the currency markets and they certainly shouldn’t be your priority when thinking about asset allocation (if you’re a sterling investor with a well-diversified portfolio, you have probably a lot of dollar exposure anyway).

But it might be worth looking for longer-term opportunities. Take emerging markets. As Ruchir Sharma notes in the Financial Times, most are in much better shape today than during previous dollar crises. Indeed, “the share of countries suffering from rapid inflation (above 5%) is higher in developed markets than in emerging markets”. Foreign investors have fled India at a record pace, reports Goldman Sachs. One option to consider is the Aberdeen New India (LSE: ANII) investment trust, with an exceptionally high haircut of 18%.

I would like to know what PPP is, but I’m too embarrassed to ask

Purchasing Power Parity (PPP) is a theory that attempts to determine how much one currency is overvalued or undervalued against another. It does this by comparing the price of identical goods in different economies. The idea is that a similar basket of goods should cost about the same wherever you go.

Why? Because if the goods are cheaper in one country than in another, then that country should be able to export them to the other for a profit. In turn, these sales would stimulate demand for the exporter’s currency, driving up the exchange rate and eliminating the difference between the two. As a result, purchasing power between countries should tend towards parity in the long term.

The best-known PPP monetary indicator is the “Big Mac index”, published by The Economist since 1986. It indicates the value of a McDonald’s Big Mac burger in US dollars, anywhere in the world. It is clear that the index is not particularly scientific, but since a Big Mac is a product that can be purchased in almost any country in the world and includes the same input costs (raw materials and labor ) and is distributed almost exactly the same wherever you go, that’s the best approximation possible.

In early January 2022, the index had a Big Mac costing £3.59 in the UK and $5.81 in the US. At the prevailing exchange rate at the time of $1.34 to the pound, this meant that a Big Mac in the UK cost just over $4.80, suggesting that the dollar was overvalued by about 20% against the pound.

PPP is useless as a trading tool – like most other assets, currencies can stay out of sync with their “fundamental” valuation far longer than it seems sustainable. However, using PPP to adjust GDP figures can be a useful way for economists to compare GDP between nations without the distorting effect of relative currency valuations, which can make the cost of life higher in developing countries than it really is.

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