How Dollar Strength Impacts Financial Markets and Your Investments
When you look at a currency converter, you might notice that the value of the U.S. Dollar can fluctuate. With the U.S. Dollar being a medium of exchange for trade worldwide, changes in the relative strength of the U.S. Dollar compared to foreign currencies can have many effects on industries, global economies, and asset prices within your investment accounts. As investing becomes more global, it’s important for investors to understand how currency fluctuations can affect the stock market and global economies.
- The U.S. Dollar’s status in international markets means any change in value can affect those markets
- Some industries benefit from a stronger dollar, others benefit from a weaker dollar
- Understanding how fluctuations in the dollar’s value can affect markets can help you maximize your investment portfolio
How does the U.S. Dollar affect the U.S. and Global Economies?
For most of the last century, the preeminent role of the U.S. dollar in the global economy has been supported by the size and strength of the U.S. economy, its stability, openness to trade and capital flows, and strong property rights and rule of law.
As a result, the depth and liquidity of U.S. financial markets is unmatched. It has positioned the U.S. Dollar as a top currency used for trading, reserves (such as the federal reserve) and even foreign exchanges worldwide. Because of this, any changes to the U.S. Dollar’s strength—up or down—might affect industries, global economies and asset prices.
In global economies, a stronger dollar—the dominant currency in trade and financial markets—tends to reduce liquidity in global markets. This is because it means other currencies, even major currencies, are worth fewer dollars. This can be a negative for economies that don’t rely on the U.S. Dollar—especially when those economies are emerging.
Regarding industry, the U.S. Dollar’s effects depend on specific circumstances. Take commodities, for example. Globally, many of them have prices based on the dollar. The stronger the dollar becomes, the less affordable or attainable those commodities might become for buyers. Demand goes down—and with it, the potential profits of US-based commodity producers.
Some industries, such as manufacturers, often compete in the global market. A stronger dollar can make it difficult for them to set price points that are affordable, profitable and competitive.
However, when importing goods from other countries, a strong U.S. Dollar could be worth more internationally. This can technically cut costs. The best part is, if they sell these goods in the U.S., they can take in even more strong U.S. Dollars. They can use these to buy more international goods at a lower cost, and the cycle of profits continues.
On the flip side, sales and earnings for US multinationals that export their goods and services might have to accept payment in a weaker international currency. So, a rising greenback can substantially affect them.
As you can see, a rising and falling Dollar can have a multitude of effects on global economies. It can also affect industries that involve international investors.
How does the U.S. Dollar affect the Stock Market?
But what if you invest in stocks? What about mutual funds? Index funds? The S&P 500? How does the U.S. Dollar affect your stocks and bonds? The relationship between the Dollar and the stock market seems simple on the surface of it. Usually, the stronger the dollar becomes (whether trade weighted, measured on the dollar index, or other exchanges), the lower the market falls.
This holds generally true. Many of the explanations for this relationship make obvious sense. However, there are a few explanations that aren’t so obvious and might need a little explaining.
Let’s take another look at commodities. Specifically, let’s examine commodities that rely on extraction, such as metals and mining. When the Dollar goes down, it affects the company’s budget—particularly regarding buying and selling. For instance, it would now cost the same amount of money to extract fewer materials. But the weakened dollar would raise the prices for those materials, helping to boost the company’s profits.
A weaker dollar also helps U.S. companies that export internationally remain competitive. This can help improve sales, which can help increase the stock prices.
Then comes the less obvious reasons a weakened dollar might help a company’s stock price grow. Many companies do a lot of business outside the U.S. Sometimes, this can account for most of a company’s profits.
These companies can take in a lot of international currency. If the value of the Dollar goes down, the new exchange rates technically increase the number of dollars the company takes in internationally. And, with increased profits comes (potentially) increased stock prices. It might not always make sense, but the stock market involves a lot of perception—not just economic realities.
The U.S. Dollar During times of Crisis
With the ongoing Ukraine war, some may ask about the U.S. dollar during a crisis. In crises, the dollar tends to appreciate and dollar liquidity becomes scarce.
Why is this?
The textbook answer: since the US dollar is the world’s dominant currency, the United States benefits from paying low interest rates on safe (risk-free) dollar-denominated assets. This includes the bonds issued by the US government. When global risk aversion elevates, investors tend to hedge against uncertainty by switching to dollar-denominated assets. This is part of their “flight to safety.”
Think of a crisis as a set of events originating from a variety of shocks causing a drop in consumption across several countries and a depreciation of their currencies. You can see how the process of “flight to safety” would create an increase in demand for dollars. This subsequently puts upward pressure on the value of The Dollar relative to other global currencies.
How this may affect various investments.
Over the long-term (10+ years), currency fluctuations between the various countries tend to balance out. But in the short-to-intermediate term (1-5 years), currencies can fluctuate all over the place. Then, they might see large relative gains or losses.
Depending on the time frame of an investor’s goals, these fluctuations in the U.S. Dollar can have drastic effects on whether that investor reaches those goals. This is most relevant for investors that may find themselves within a “Red Zone” of life. They may need a significant portion of their invested dollars for a life change, such as for their retirement plan or a change in health within the next 5-7 years.
For these investors, understanding the relative strength or weakness of the Dollar is important because it can help them optimize their investment portfolio. The strength of the dollar can be just as pertinent to achieving financial goals as just having a “diversified portfolio”.