Why Investors Need to Watch the Rising Dollar

The volatility in U.S. stock and bond markets stemming from the U.S. Federal Reserve’s (Fed) move toward tighter monetary policy has made its way to global currency markets, with the U.S. dollar soaring compared with global rivals. So far this year, the dollar is up about 8% against a basket of other major currencies. It has risen a staggering 13.6% over the past 12 months and recently hit a 20-year high. 

Though some observers believe the hawkish Fed and investors’ flight to the relative safety of the dollar amid geopolitical strife is driving the rise,  Morgan Stanley’s Global Investment Committee thinks today’s currency dynamics may be more complicated, with divergent central-bank actions also driving relative weakness in other currencies. To understand this dynamic, consider: 

• Japan, where the central bank is implementing “yield-curve control”—an effort to actively manage borrowing costs across different maturities—alongside money-printing to engineer higher structural inflation and a path away from nearly 40 years of deflation. Accordingly, the yen recently tumbled to a 20-year low against the dollar.

• Europe, where weakness has emerged in the euro, as the risk of recession grows around the Russia-Ukraine war and as the European Central Bank tries to delay inevitable monetary tightening.

• China, where implementation of zero-COVID policies has weakened the outlook for an economic recovery and pushed its central bank toward easing policy, causing the yuan to depreciate.

The implications of a stronger dollar for financial markets and the economy are also more complex than many realise, making the path ahead riskier for investors and policymakers alike: 

• The typical investing playbook for a strong U.S. dollar may not work well in today’s market. For instance, commodities usually move inversely to the dollar, so theoretically we should see prices fall. But we haven’t. Instead, commodities-based inflation remains significant, due to the dual supply shocks caused by COVID-19 and Russia’s invasion of Ukraine. A strong dollar also tends to bode ill for emerging markets that are dependent on dollar-denominated debt by making it harder for these regions to service this debt. Today, however, many emerging-market regions are in excellent fiscal shape, with plenty of foreign-exchange reserves. In fact, those that supply fuel, fertiliser, food and metals, as is the case for much of Latin America, actually stand to benefit from the global supply squeeze. And in equities, many investors today are favoring defensive stocks and not names that would typically benefit from a strong dollar, such as retailers and homebuilders.

• The soaring dollar adds risks for the Fed as it seeks to tame inflation without slowing the economy into a recession. In the near term, the stronger dollar may bolster the purchasing power of companies and consumers when it comes to imports, thus helping ease inflationary pressures. But the dollar’s strength can also hurt U.S. exports and the translation of overseas profits by U.S companies, posing headwinds to growth. Longer term, the currency’s strength may help further tighten financial conditions, just as the Fed is shrinking its balance sheet and international flows into the U.S. market could be slowing in line with recoveries elsewhere.
  

In short, continued U.S. dollar strength could complicate the outlook for the economy and markets, implications that may be underappreciated by investors at the moment. We think investors should watch real yield differentials for signs that the U.S. dollar is peaking and consider rebalancing international exposure, especially in equities. The U.S. dollar may peak in the next three to six months, and a tailwind may develop, enhancing regional market recoveries.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from May 2, 2022, “Watch the Greenback.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.