Home Research Stronger dollar may ignore potential risks to markets and economy

Stronger dollar may ignore potential risks to markets and economy

by surfsidefinance
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The volatility in U.S. stock and bond markets caused by the Federal Reserve’s tightening monetary policy has spilled over into global currency markets, with the U.S. dollar soaring compared to its global rivals. So far this year, the dollar is up about 8% against a basket of other major currencies. It has risen a stunning 13.6% in the past 12 months, recently hitting a 20-year high.

While some observers believe a tough Fed and a shift by investors to the relative safety of the dollar amid geopolitical conflicts are driving the greenback higher, the Morgan Stanley Global Investment Committee believes today’s currency dynamics may be more complex, with different actions by central banks also driving relative weakness to other currencies. To understand this dynamic, consider.

Japan, where the central bank is implementing “yield curve control” – actively managing borrowing costs across maturities – as well as printing money to engineer higher structural inflation and emerge from nearly 40 years of deflation. years of deflation. As a result, the yen recently fell to a 20-year low against the dollar.
In Europe, the euro has weakened as the risk of recession around the Russia-Ukraine war increases and the European Central Bank tries to postpone the inevitable monetary tightening.
In China, the implementation of a zero COVID policy has weakened prospects for economic recovery and pushed its central bank to adopt easing policies, leading to a depreciation of the yuan.
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The impact of a stronger dollar on financial markets and the economy is also more complex than many people realize, exposing investors and policymakers alike to greater risk.

Typical investment strategies for a strong dollar may not work well in today’s markets. For example, commodities typically move in the opposite direction of the dollar, so in theory we should see prices fall. But we haven’t. Instead, commodity-based inflation remains high due to the double supply shock caused by COVID-19 and Russia’s invasion of Ukraine. A strong dollar also tends to be ominous for emerging markets that rely on dollar-denominated debt, as it is more difficult for these regions to service that debt. However, many emerging market regions today are in good fiscal shape and have ample foreign exchange reserves. In fact, those countries that supply fuel, fertilizer, food and metals, as is the case in much of Latin America, will actually benefit from the global supply crunch. On the equity side, many investors today favor defensive stocks over those that would normally benefit from a strong dollar, the
A soaring dollar adds risk to the Fed as it tries to curb inflation without letting the economy slow down into recession. In the short term, a stronger dollar may help ease inflationary pressures by increasing the purchasing power of businesses and consumers on imports. But a stronger dollar could also hurt U.S. exports and the ability of U.S. companies to turn overseas profits into a drag on growth. In the longer term, a stronger currency could help further tighten financial conditions, just as the Federal Reserve is shrinking its balance sheet, and international flows into U.S. markets could slow as recovery elsewhere takes hold.
In short, continued strength in the dollar could complicate the economic and market outlook, and investors may not fully understand the implications at this time. We believe investors should watch real yield differentials for signs that the dollar is peaking and consider rebalancing international exposure, particularly to equities. The U.S. dollar could top out in the next three to six months and there could be tailwinds that could fuel a recovery in regional markets.
This article is based on Lisa Shalett’s May 2, 2022 Global Investment Committee weekly report, “Focus on the Dollar. Ask your Morgan Stanley financial advisor for a copy.

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