Investing

Trying to Make Sense of the US Dollar

The US Dollar (USD) has become increasingly more interesting in 2020. Sure it has been the world’s reserve currency for decades and is the primary means to pay for important commodities such as oil, but a movement away from USD that began several years ago continue to strengthen. As Americans, I think we sometimes take for granted just how much our lives benefit from having the world’s reserve currency as our local currency. Without getting into the plumbing of how things work, having the world’s reserve currency gives the US and its citizens a lot of economic, financial and political power that other nations don’t necessarily have. I don’t say this to brag or to be arrogant but those powers contribute to our standard of living, our liberty and our overall standing in the world.

Regardless of USD’s standing in the world, it is a free floating currency and is subject to foreign currency fundamentals and supply and demand, which causes it to fluctuate impacting its purchasing power throughout the world. As USD strengthens relative to other currencies such as the Euro or Yen, it is able to purchase more in terms of those currencies. As USD weakens relative to other currencies, it purchases less in the form of goods or services in terms of other currencies. Additionally, as USD strengthens or weakens, foreign visitors to our country get less or more for their local currency. So as you can imagine, when USD is weak relative to other currencies in the world we may see an increase in foreign visitors (their currency goes farther here) while when USD is strong we may observe a decrease in foreign visitors (there currency doesn’t buy as much here).

With USD as the reserve currency, many important transactions including commodity purchases and loans are denominated in USD. As a result, many countries are forced to hold USD currency reserves so they can not only pay their USD denominated obligations but so they can also be hedged against currency movements. This requirement to hold USD currency reserves and other US financial measures is one of several reasons why many countries have been attempting to find ways to circumvent the reserve status of USD. I’m not getting into the details of what countries have been doing but suffice it to say several countries are searching for alternatives to USD.

As the reserve currency and the local currency of the home to the most important economy and financial market in the world, USD is also viewed as a safehaven during times of financial stress such as the Great Financial Crisis of 2008 and the global pandemic of 2020. USD strengthens or rises relative to other currencies during these periods of stress while risk assets such as stocks decline. It’s during those periods of stress where the correlation between USD and risk assets is effectively -1, meaning if USD is going up risk assets are going down almost one for one.

While foreign currency can appear to be an esoteric topic, it’s a very important part of the overall plumbing of the broader financial system and investment markets. Since the global pandemic came home to roost in the US this year, an inverse relationship between USD and risk assets, such as stocks, has existed as depicted in the chart below.

While on the surface this relationship isn’t necessarily unusual in the context of a crisis, it is unusual in that stocks are at or near all-time highs and USD continues to exhibit noticeable weakness. Lots of theories exist as to why USD should strengthen or weaken in the current environment. If the current inverse relationship holds then being able to figure out what USD does next holds the answer to what risk assets will do next. I’ve yet to determine on my own or read anybody else that has a beat on this so stay tuned.