Why Does The “Strong Dollar” Matter?
From commodities like gold and oil, to emerging market debt and equities, you will hear the price movement of almost everything tied to the price of the U.S. dollar. And when it’s performing well in the market, it can be referred to as the “strong dollar”. There is significant justification to the proliferation of these headlines.
The dollar is the world’s reserve currency and central banks across the globe hold it to maintain confidence in their own currency. Furthermore, commodities like oil and gold are bought and sold all across the globe, yet the vast majority of trades are transacted in U.S. dollars, not local currencies. Emerging market countries will even issue their debt in dollars in order to pay a more attractive interest rate.
By understanding the prevalence of the dollar around the world, we can begin to understand why so many assets are tied to it. The value of a currency is denominated in terms of another foreign currency. For example, one U.S. dollar will buy 110 Japanese yen, but that same dollar would only be able to buy 0.86 euros, and these rates change every day. As a currency strengthens or weakens it is worth more or less in terms of another currency. That means one dollar buys more or less yen or euros as the price fluctuates.
If someone in Europe is trying to buy an asset that is denominated in USD, it is not only the price of the asset itself that changes, but also the price of the euro relative to the USD. The price of an asset could remain the same, but the relative purchasing power of the euro could decrease relative to the USD. The decrease in purchasing power of the euro effectively increases the price of the asset they were trying to buy in USD. Apply this concept to most assets denominated in USD and you can begin to see why the movements in gold, oil, emerging market debt, and many others are so often tied with the movements in the dollar and why so many people perk up at the mention of a “strong dollar”.
If so many assets are tied to the dollar, then what is ultimately driving the price of the dollar? In the most basic sense, it is the supply and demand of a currency that drives the price. The Federal Reserve is undergoing a tightening of monetary policy, which is meant to reduce the money supply in order to stabilize the economy. Reducing the money supply directly translates into fewer dollars circulating. Investors and speculators alike understand these policy changes and it begins to be reflected in the price of the dollar over the long run.
There are wide ranging effects created by price changes in the U.S. dollar. While day to day volatility may not be driven by such macro factors, it is widely accepted that the dollar is a major driving factor in many global assets. Next time you see the “Strong Dollar” in a headline, you’ll know why it has such a large impact.
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