Q&A: Dollar Dominance—Can It Continue?

By Tracey Manzi, CFA, Senior Investment Strategist, Investment Strategy


The US dollar has been getting a lot of attention these days. This is not surprising given the greenback has gained over 17% against a basket of currencies this year to levels not seen in over 20 years.* While moves of this magnitude are not unprecedented, the dollar’s steady climb is starting to have spill-over effects on the rest of the world. This has implications for the economic performance of various regions and on the financial markets. Sanctions against Russia have also revived investor concerns about whether the dollar can maintain its role as the world’s reserve currency. In this Q&A we delve into some of the more pressing questions on investors’ minds.

Q: Why is the dollar so strong?


A: The surge in the dollar this year has primarily been driven by the hawkish Federal Reserve (Fed). With inflation running near a 40-year high, the Fed is in the midst of one of its most aggressive tightening cycles in decades—raising rates from near zero at the start of the year to between 3.0% and 3.50% following the September rate-setting Open Markets Committee meeting. Further rate hikes are expected for the remainder of this year. The Fed’s policy stance has been the key factor driving the dollar higher, particularly as the Fed is on track to tighten more aggressively than other central banks. Higher relative interest rates are supportive for the US dollar. The challenging macroeconomic backdrop and uncertain geopolitical climate has also contributed to the ongoing strength of the US dollar. It is not surprising to see investors flock to dollar-denominated assets during periods of economic stress or elevated uncertainty as the US is considered a ‘safe-haven’. With no end in sight for the Russia-Ukraine conflict, Europe on the brink of recession and China’s zero-COVID policy stance still restraining Chinese economic growth, the dollar’s strength seems likely to persist.

Q: What are the implications of a strong dollar?


A: Aside from the obvious—it’s cheaper to take a vacation overseas—the US dollar plays an important role in the world economy. That is because it is the currency that powers global trade. The price of nearly every commodity contract traded on the world markets — from oil to copper to wheat — is priced in US dollars. Therefore, when the US dollar is strong relative to other foreign currencies, it drives up the cost of imported goods.

YTD Foreign Currency Returns against the US dollar


Source: FactSet, as of 20/09/2022

and feeds inflation directly into other economies. This is precisely what is happening today as the strong dollar is contributing to inflation pressures globally. While commodity prices tend to have an inverse correlation with the US dollar, this is not always the case. Commodity prices spiked after the war in Ukraine broke out and remained elevated as supply chain challenges persisted and weather-related issues impacted availability, at least until recently. This only compounds the challenges faced by the rest of the world. While the strong dollar has been problematic for others, it has been beneficial for the US economy as it holds down the price of imported goods and restrains domestic inflation. The dollar’s strength can also pose a headwind for US companies that generate a significant portion of their revenue overseas. That’s because their overseas earnings are reduced when they are translated back into US dollars. We’ve already seen some high-profile companies provide negative warnings over the Q2 earnings season. This is definitely something to keep an eye on as the Q3 earnings season approaches.

Q: Is the dollar’s role as a reserve currency under threat?


A: When Western governments took the unprecedented step of freezing Russia’s foreign exchange reserves following its invasion of Ukraine earlier this year, many started to wonder whether this would accelerate the displacement of the dollar as the world’s pre-eminent reserve currency. The logic being that others would rapidly diversify their reserves away from the dollar to reduce the risk of their assets suffering the same fate. Speculation about the dollar’s demise has been ongoing for decades, so these concerns are not new. But, despite these ominous predictions, the reality is there is, as yet, no serious alternative to the US dollar. That is because the US dollar continues to be the most widely used currency in global financial transactions. It is also because the US Treasury market is the largest, most liquid and stable market in the world. And because of this, the US dollar continues to represent the majority of the world’s global reserves, which according to the International Monetary Fund, stand at around 59% today. While it is true that the dollar’s share of global reserves has decreased over the last two decades, it still remains far above the next biggest market, the euro, which only accounts for around 20% of total reserves. Although there is speculation that China may have ambitions to dethrone the US dollar one day, we do not think it provides a serious threat. Less than 3% of the world’s exchange reserves are held in Chinese yuan today. The reason for this is simple. It is because the yuan is still not a fully convertible currency, which means that its exchange rate is still strictly managed by the Chinese monetary authorities. So, for now, we do not think the dollar is at risk of being replaced as the world’s reserve currency.

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