The recovering value of the U.S. dollar and what it means for investors

July 22, 2022 | Market news

Key takeaways

  • In July, the U.S. dollar’s value reached parity with the euro for the first time in 20 years.
  • The dollar’s current strength relative to other international currencies is a global phenomenon.
  • For U.S. investors, a strong dollar has the potential to magnify losses in foreign investments that decline in value.

One of the major economic stories of recent months is the surge in the U.S. dollar’s value relative to other currencies. In mid-July 2022, the dollar reached parity with the euro, Europe’s common currency. This means the currencies have matching values (parity means one dollar is equal to one euro), the first time since 2002 that the dollar reached such a level of relative strength. While most of the attention is on the relationship between the dollar and euro, it’s notable that the dollar also gained against other major currencies. For instance, since 2020, the dollar is up 31% vs. Japan’s yen. The dollar gained 14% against the British pound since June of 2021. U.S. currency also moved 10% higher against the Canadian dollar since March 2020.1

“This is a reflection of the global flow of funds,” says Rob Haworth, senior investment strategy director at U.S. Bank. “At the present time, more foreign money is flowing into the U.S. rather than the other way around.” According to Haworth, the direction of money flows helps determine the relative strength of a particular currency.

A stronger dollar offers clear advantages for Americans who travel overseas, increasing their purchasing power. But from an economic and investment standpoint, the stronger dollar is a mixed bag. You may want to consider the potential impact of currency trends as you position your investment portfolio.

A long, slow recovery for the dollar

The dollar’s recent climb to parity with the euro was years in the making. As recently as 2008, it took nearly $1.60 to purchase the equivalent of one euro. The dollar recovered from that point, but with a great deal of fluctuation in value along the way.

In 2015, the two currencies came close to parity, as it took $1.06 to purchase one euro (€). But from that point, the dollar weakened again. At the end of May 2021, the dollar stood at $1.22 to €1. It improved, to $1.14 at the end of 2021 and to $1.04 at the end of June 2022, until reaching parity in mid-July.

Haworth credits the interest rate environment as a key factor in current currency movements. “Thanks to the Federal Reserve’s (Fed’s) recent decision to raise the federal funds rate quickly, bond yields in general are higher in the U.S. than in Europe, and even more so when considering inflation.” More attractive real yields (government bond yields less the rate of local inflation) tend to draw more foreign investment dollars, improving the demand for dollars and driving its value higher.

“The risks of a recession in Europe appear to be more pronounced than the fears of a recession in the U.S. in the near term.” Haworth says that many currently view the U.S. as a safe haven for their investments. This is due at least in part to economic fallout from Russia’s invasion of Ukraine. Russia is a key supplier of oil and natural gas to much of Europe. Should the flow of Russian resources be interrupted, some European countries may need to reduce their energy usage, implying slower economic growth.

Dollar strength across the board

The dollar’s recent recovery is a global phenomenon. Its far-reaching strength is visible in the Nominal Broad U.S. Dollar Index. This index, created by the Fed, tracks the dollar’s position on a worldwide basis. It measures the U.S. currency’s value relative to a basket of other currencies, based on their relative importance to U.S. import and export activity.

In early July, the index stood at more than 122, reflecting significant U.S. dollar strength versus other currencies across the globe, slightly below the recent all-time high of 126.14, which occurred in March 2020 during the early days of the COVID-19 pandemic. At the end of 2021, the index stood at 115.40 (signaling a weaker dollar) and was even as low as 107.08 in January 2018. The index was last below 100 (indicating a significantly weaker dollar on a global scale) in December 2014.2

It should be noted that currencies fluctuate constantly. Changes don’t tend to be dramatic on a day-to-day basis, but trends develop over time. Based on the Nominal Broad U.S. Dollar Index, a general trend favoring the dollar has been in place going back to 2021.

The economic impact of currency fluctuations

A positive feature of a stronger dollar is the lower cost of imported products from other countries. For example, if a car made in Germany is valued at €50,000 and then is imported to the U.S. when the dollar stands at $1.20 to €1, the retail price of the car in the U.S. would (theoretically) be $60,000 (20% more than its European price to reflect the currency exchange rate). If the dollar were to appreciate to $0.90 to €1, the car’s value in the U.S., using the same assumptions, would decline to $45,000, a significant savings for a U.S. consumer.

However, a strong dollar can also detract from revenues generated by multinational companies based in the U.S. The net income earned from foreign sales will decrease once exchanged into dollars. A stronger dollar means U.S. companies that export products abroad will be less competitive because the price of the product translated into euros or another currency is higher, which can lead to lower sales as foreign buyers shift to lower cost alternatives.

“The dollar’s recent strength hasn’t resulted in a major impact on corporate earnings just yet,” says Haworth, “but if it persists, that might be harmful to larger, multinational firms and, relatively speaking, beneficial to smaller companies.” This is because smaller firms sell most of their goods and services in the domestic market while still benefiting from a stronger dollar which lowers the price of imported components. As a result, small, domestically focused companies have fewer concerns about how currency conversions could impact their revenue streams.

At the same time, Haworth points out that the stronger dollar creates some additional pressure for multinational companies based overseas. “Many raw materials, such as oil, are priced in dollars, so European companies face a larger increase in the price of energy than we’re experiencing in the U.S.”

Investment implications of the stronger dollar

Corporate earnings can be affected by currency trends. Yet Haworth says the impact of currency movements shouldn’t be a major consideration for investors as they assess the value of specific stocks. The same is not true, however, for U.S. investors who include overseas-based investments in their portfolios.

For example, consider the value of an investment in the MSCI European Union (EU) Index. From January 1 through June 30, 2022, the index, in local currency terms, suffered a decline of 19.08%. However, the net return for a U.S.-based investor in the fund, translated back into dollars, was a decline of -25.60%. In other words, the strong dollar detracted from the return, resulting in an even larger loss during what has been an already challenging environment for equities. If the dollar weakened compared to the euro, the loss would be reduced after the currency exchange.

“The dollar’s recent strength hasn’t resulted in a major impact on corporate earnings just yet. But if it persists, that might be harmful to larger, multinational firms and, relatively speaking, beneficial to smaller companies.”

- Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management

“This doesn’t mean if the dollar is strong that you should not include a global equity position in your portfolio,” says Haworth. “Currencies are less volatile than stocks as a whole, and their direction is challenging to predict, given numerous factors that influence relative currency values.” Haworth believes investors should be aware of how currency trends may impact investment returns, but not base their “buy-and-sell” decisions on those trends.

Future value of the dollar

Will the euro and other currencies rebound against the dollar, and if so, when? “It’s really a question of when fund flows begin to change,” says Haworth. He notes that currency trends are most prominently driven by relative inflation considerations between the U.S. and the locale of another currency, as well as comparative central bank policies.

In the current environment, the Fed has been far more aggressive than the European Central Bank (ECB) in raising short-term interest rates. As a result, U.S. fixed income investments pay more attractive yields than those offered by European markets. This drove more investment dollars into U.S. Treasuries. Therefore, the dollar is in higher demand and as a result, increased in value versus many other currencies.

At some point this trend will reverse. Currency markets fluctuate, but as Haworth emphasizes, in unpredictable ways. Given the sometimes-arbitrary nature of currency movements, they should rarely be a decisive factor in your investment strategy. Be sure to consult with your wealth management professional to explore how currency trends may impact your portfolio.

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