One byproduct of this year's steady surge in inflation has been a sharp increase in the value of the U.S. dollar, relative to the rest of the world's currencies.
As of mid-July, one dollar purchased one euro, a more than 18% rise for the U.S. currency from the exchange rate a year earlier and its first taste of parity with the European currency since 2002. Additionally, the dollar capped a one-year, 14% rally against the British pound to touch highs last seen amid the pandemic's onset and posted a 25% one-year gain against the Japanese yen.
While seemingly counterintuitive—if it takes more dollars to buy groceries or a gallon of gasoline, how can a single dollar be more valuable? The rise is more reflective of global market dynamics that have little to do with how much your household spends each week.
"There are many factors at play in the global foreign exchange market and currently, many of those favor the U.S. dollar," said Peter Tibbles, senior vice president of Foreign Exchange at BOK Financial®. "First and foremost, the Federal Reserve has raised rates more aggressively than other central banks around the world and has said it intends to keep raising them higher."
As long as that trend remains in place, expect to hear more about the soaring dollar, relative to other currencies.
Dollar's value bolstered by Fed moves
The Fed's influence on the value of the U.S. dollar is tied into its key lending rate, which it increased by half a percentage point in May, three-quarters of a percentage point in June and another three-quarters of a percentage point in July.
Those moves led to a sharp increase in the interest rate, or yield, paid on short-term U.S. Treasury notes. By comparison, the world's other leading central banks have taken less abrupt paths to attack inflation: the Bank of England has limited its rate hikes to a quarter-point thus far, the European Central Bank implemented its first rate increase in 11 years in July and the Bank of Japan is sticking to an ultra-low-rate policy.
The result is that yields on government bonds issued by the U.K., European Union and Japan have remained lower than those on Treasuries. Therefore, returns aren't as attractive as with U.S.-based bonds. Plus, currency traders capitalize on the spread between the yields, which enhances demand.
In addition, Tibbles said two other factors have aided the dollar's rally:
- The dollar's longstanding reputation as a safe-haven currency in times of global strife, which kicked into action in late February, when Russia attacked Ukraine and raised concerns that larger conflict would draw in Europe and other Western states.
- Soaring prices in global commodity markets, where raw materials are priced in U.S. dollars and increases typically push the value of the dollar higher. Most notably, energy and grain prices have resisted broad declines as Ukraine is a large producer in both industries and sanctions against Russia's oil and gas industries have squeezed supplies.
Beneficiaries include travelers to Europe
On a day-to-day basis, the value of the U.S. dollar likely has minimal influence on your life.
"As dollar-centric consumers, whether the U.S. dollar is strong versus the euro, yen or emerging market currencies doesn't impact the transactions we do in dollars," said Steve Wyett, chief investment strategist for BOK Financial. "Where we do see a benefit is that it makes imported goods cheaper."
In addition, if you're traveling outside the U.S. in the next few months, your purchases abroad will likely be considerably less expensive than they were a year ago. The discounts may be enticing enough to move up a long-planned trip abroad, according to Kimberly Bridges, director of financial planning at BOK Financial, but only if it fits your broader financial plan.
"We generally advise matching your savings strategy with the goal-time horizon, so if you were planning to do a big vacation in the next couple of years, those funds probably aren't in the market right now, and moving up the European vacation to take advantage of the strong dollar might be an easy shift," she said. "But if they're invested in the market and you need to sell some stock and incur investment losses to fund the trip, you may want to pass."
In general, Wyett said the dollar's strength or weakness has a limited impact on a well-diversified investment portfolio. Although emerging market investments tend to struggle in such an environment, U.S.-based companies with operations around the world hedge their currency exposure to protect against swings in either direction.
Keys to a reversal
Notoriously volatile, the foreign exchange market can back away from the U.S. dollar as quickly as it has piled on in 2022.
As he monitors the shifting sands for his clients, who are usually looking to lock in exchange rates on transactions with customers outside the U.S., Tibbles is watching for changes in three key factors:
- Inflation. Once there's a sense that the rate of price increases has peaked, analysts will start calculating when the Fed will stop raising its key lending rate.
- Unemployment. A jump in the jobless rate, which is currently lingering near 50-year lows, would indicate the economy is softening, which would prompt the Fed to ease off its rate hikes.
- The war in Ukraine. Already influencing higher commodity prices, if this escalates in any way, the dollar will likely rise further.
"Once it looks like inflation is under control and the economy has slowed, the cycle shifts and the market looks for the Fed to cut rates to encourage more investment and borrowing," Tibbles said. "That's typically when we see the dollar weaken."
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