In mid-July, going relatively unnoticed, a historic event occurred in the foreign exchange market: the soaring U.S. dollar traded at parity with the Euro. A level that has only been hit once before, and that was over 20 years ago.
This year in particular has been a historic one for the U.S. dollar, which seems to be doing nothing but going straight up, almost 17% so far against an index of a basket of currencies. That’s an enormous currency move, with very few, if any, previous periods mirroring that kind of strength over such a short time frame.
What’s going on is straightforward international interest rate arbitrage, driven by the much higher interest rates that have been prevailing in the U.S., especially now that the Fed has been aggressively raising interest rates to battle startling levels of rising inflation. It’s the biggest and most important fight against inflation the Fed has seen since the days of former Fed Chairman Paul Volcker, who is famous for allowing short-term rates to move up above 20% to finally crush the stubbornly high inflation rates of the late 1970s.
The Fed is up against a significant fight to get inflation levels down to where they want them, but the Fed won’t have to take interest rates nearly as high as Volker did to get the job done, according to McGill University economics professor Francisco Alvarez-Cuadrado.
Heightened Geopolitical Uncertainty
Another element powering the U.S. dollar higher — perhaps even the most important factor — has been the sudden heightened geopolitical uncertainty prompted by the Russian invasion of Ukraine. It’s a phenomenon called “fight-to-quality.” The thinking in this particular case is, if general war were to break out, the U.S., with its unmatched military might, would be the country most likely to prevail. And the U.S. currency would be the safest bet.
The dollar is the currency that drives international trade, and its rise so far this year “has left a trail of devastations.” Driving up the cost of food imports and deepening poverty across much of the world; fueling a debt default and toppling a government in Sri Lanka; and heaping losses on stock and bond investors in financial capitals everywhere, according to Bloomberg Opinion.
The greenback now stands at a record high, according to some measures. And the Fed has made it clear that it’s going to keep driving interest rates up to quell inflation — even if it means pushing the U.S. into a recession and possibly taking global economies along with it.
There seems to be little on the horizon that could break the dollar’s climb. The yen at around 148 to the dollar traded at a record low, due mainly to the fact that the Bank of Japan has failed to follow the Fed by raising interest rates. Japan does not have the inflation problems so prevalent elsewhere and in fact has been dealing with deflation for many years.
The bottom of the British pound has absolutely fallen out, hitting a record low of 1.03 to the dollar recently. The problem in England is there is a new prime minister, Liz Truss, who has introduced a controversial economic program that involved massive tax cuts that were even criticized by the IMF, a rarity for a highly industrialized country like the U.K.
And all of Europe has enormous issues with a historic surge in energy prices that is likely to require huge subsidies by governments, all of whom will need to borrow large sums to help ease the pain of massive energy price increases for their citizenry.
A Headwind to Earnings
During second-quarter earnings releases, one company after another with big overseas revenues — Microsoft, Apple, and Alphabet — blamed the strong dollar as a major factor dragging down their earnings. And emerging market economies, most of which have floated dollar-denominated bonds that now have to be paid back in dearer dollars, are at their wit's end with some like troubled Sri Lanka mired in default.
Analysts say companies like Apple, which has half its sales overseas, could see their third-quarter earnings cut by more than 5% as a result of the strong dollar. Nike, which reported on its second quarter Friday, and also gets half its revenue overseas, said over the last 90 days in particular the U.S. dollar has been a big headwind to earnings without saying by exactly how much.
“There is no magic wand to reverse the dollar's strength immediately, with the Eurozone hampered by the war in Ukraine and China’s growth uncertain,” said Ahmed Abou-Zaid, an economics professor at Eastern Illinois University. “There is just no other way to go than with the U.S. dollar because there’s no alternative to the dollar no matter where you go and it's smashing everything else as a result — economies, other currencies, corporate earnings.”
The US currency’s turgid ascent is a big part of daily life around the world because it’s the lubricant for global commerce — roughly 40% of the $28.5 trillion in annual global trade — is priced in U.S. dollars. Its relentless rise risks creating a self-sustaining vicious circle.
“You have recession concerns that result in dollar strength and then tightening financial conditions leading to more recession concerns,” Abou-Zaid said. “There’s no quick solution around this.”
Demand for the dollar has been hot for the simple reason that when global markets become uncertain (such as in Ukraine and Taiwan) investors look for a safe haven. And as the Bank for International Settlements, the central bank’s central bank, put it, that security is fulfilled now primarily by the U.S. dollar.
To Hedge or Not to Hedge
The size and strength of the U.S. economy remain unequaled. U.S. Treasury securities are still the safest place to put money and the dollar makes up the huge lion's share of central bank foreign-exchange reserves worldwide. And U.S. treasury yields are soaring in a historic manner, so much so that interest charges are now the federal government’s largest budget item.
For a country like Canada, whose economy is driven one-third by trade, the value of its currency is all important. But in the U.S, the world’s largest and most dynamic economy, only 10% of economic activity is driven by trade.
Thus there are few American companies, large or small, that are entirely or even mostly dependent on international trade. But for the CFO, no matter if it's a large company or small, the question when forex markets are bent out of shape becomes the eternal one: to hedge or not to hedge?
The practice of foreign currency hedging exists only when companies have international operations and exposure to foreign currencies because hedging is not necessary for transactions carried out only in local currency.
Since hedging is optional for corporate treasury operations, questions raised by this strategy revolve around when and how to hedge and weigh what possible benefits it might bring against its likely costs.
You can hedge with full access to instruments like futures contracts, forward contracts, options, and swaps, among others. Interest rate curves, economic reports, and news focused on market prospects must be studied because the assertiveness of your insights and information will determine the success of your hedging strategy.
And it sure doesn’t look like the Fed’s going to be any help with the strong U.S. dollar by easing up soon on its interest rate hikes. On Aug. 5 the Bureau of Labor Statistics announced a huge increase of 532,000 jobs created in July, twice what economists expected. Needless to say, the jobs data sent the dollar soaring to even newer highs.
And the job market in August was still going strong with 315,000 new jobs.
Editor’s note: This is part one of a two-part series. You can find part two here.
In the future, CFO will be on the lookout for firms heavily, or even totally, dependent on exports and thus are in a difficult spot as the roaring greenback appropriates more of their margins. If you are a CFO of such a business, please reach out to us at [email protected] and tell us about how you are dealing with the travails surrounding your currency exposure and exposure to a currency that appears to have forgotten the meaning of gravity.
Correction: Previously attributed comments to Matt Tevis were made in error and have been removed.