The US dollar is on a roll, but all is not well

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(CNN Business) — The US dollar is on a streak. Driven by the Federal Reserve’s aggressive policy tightening, the value of the greenback is appreciating to multi-decade highs and crushing currencies around the world.

Typically, it is the emerging market countries that bear the brunt of a strong dollar. This is because US politicians, investors and businesses have encouraged developing countries to peg their currencies to the dollar. The strong dollar crushes the poorest countries that must meet their debt obligations in dollars and depend on the United States for food imports.

But something strange happens during this ascent. The dollar is appreciating more against the currencies of rich economies than against those of emerging markets.

Investors looking for a good return on government bonds often turn to high-risk developing nations because they pay high interest rates. When the Federal Reserve raises interest rates, investors realize they can get those payments without the risk and move their money to the United States. This boosts the dollar, but sends developing market currencies plummeting.

But central banks in emerging countries are also tightening monetary policy as developed countries keep interest rates relatively low, so the rules have changed. This, coupled with fears of a war-induced recession in Europe, has led investors to invest in the dollar.

Trouble Ahead: the euro is at its lowest level against the dollar in 20 years, and the British pound is at its lowest level against the dollar since 1985.

The Fed’s trade-weighted dollar index, which measures the value of the dollar based on its competitiveness with its trading partners, has appreciated 10% this year against the currencies of other advanced economies, its strongest level since 2002. By comparison, the dollar is only up 3.7% against emerging market currencies.

The change adds to a host of challenges that are already driving up inflation in Europe, as the continent heads into winter with a looming energy crisis. Japan’s energy import prices are also rising, and worsening because of the dollar. The major companies in the S&P 500, most with a strong global presence, aren’t thrilled about all this either.

The cycle continues: Federal Reserve officials have said they will likely keep raising interest rates through 2023, so there won’t be much easing in the near future. “The dollar could rise further if not countered by more assertive moves, especially by the European Central Bank (ECB), which is due to meet this week for a second rate hike to combat rising inflation in euro zone,” said Quincy Krosby, chief global strategist at LPL Financial.

Bad for business: S&P 500 companies with a global presence also have to deal with a strong dollar that dents their revenue growth. About 30% of S&P 500 companies’ revenues are earned in markets outside the US, Krosby said. During earnings season, several companies said the dollar’s strength had already weighed on revenue growth. LPL Financial estimates that the strength of the dollar subtracted 2 to 2.5 percentage points from the S&P 500’s earnings in the second quarter.

Conclusion: the dollar’s strength should stop accelerating when the Federal Reserve stops raising interest rates, Krosby said. But there are external forces that could keep the value of the dollar skyrocketing even after the Fed’s Federal Open Market Committee calls it a day: the current weakness in the euro and other currencies is not just due to the Fed. It also reflects investors’ fear of an impending recession in Europe. Therefore, investors take refuge in the dollar, at least for the time being. The greenback is expected to remain strong for a while.