Table of contents1 | The World Reserve Currency2 | Dollar Dominance3 | Dollar Principles 4 | The Dollar Index5 | The growing supply of dollars6 | The Low Rate Effect7 | The PMI Growth Effect8 | Early 80’s Business Cycle9 | The Denominator Effect
The World Reserve Currency
The U.S Dollar is the daddy of all currencies. It's one of the strongest macro forces influencing markets. It is often referred to as the dollar wrecking ball because when it moves fast it rattles everything. Understanding the dollar's impact on markets can significantly improve your investing or trading decisions.
Dollar Dominance
- More than 75% of global transactions are done in U.S. dollars.
- An estimated 40 trillion dollars are in circulation worldwide.
- Most goods and services are priced in dollars, including the largest commodity on the planet, Crude Oil.
- The dollar is backed by the strongest military force in history.
- The largest corporations on earth are priced in dollars.
Most major businesses in foreign countries demand payment in dollars.
The largest commodity on earth, Oil, is sold in dollars.
Dollar Principles
1) The Denominator Effect- A strengthening dollar tightens financial conditions pushing asset prices lower.
- A weakening dollar eases financial conditions pushing asset prices higher.
- When markets are shocked by economic uncertainty and global risk, assets sell-off into dollars.
- When economic risks dissipate, and investor confidence returns, dollar demand decreases, and those dollars are used to buy assets.
- Hawkish policies have a strengthening effect on the dollar
- Dovish policies have a weakening effect on the dollar
The Dollar Index
You probably keep count, in some way or another, of how many dollars you've saved, spent, or recently got paid in. However, did you know the value of each dollar fluctuates on a day-to-day basis? This is because the dollar's real value is weighted against other global currencies, much like the way your buying power is weighted against prices. If prices go up, your dollar is less valuable (it buys less). When prices go down your dollar is more valuable (it buys more). The dollar index is primarily measured against the following currencies:- Euro
- Swiss franc
- Japanese yen
- Canadian dollar
- British pound
- Swedish krona
$DXY
The dollar index was established in 1973 and started at a base of 100. Anything above would be considered strengthening and below weakening. In the early 80's the dollar got up to 160 while the 2008 financial crisis brought it down to 80. As of May 2022, the dollar is hovering around $100...
- What could be moving the dollar?
The growing supply of dollars
As the money supply increases, it devalues the value of each dollar, suppressing dollar strength.- As the dollar is the most demanded currency on earth, Central bank policy ensures the expansion of its supply.
The Low Rate Effect
Over time, the lowering of bond yields...
- stimulates demand for lending and borrowing, expanding the base-quantity-supply of dollars.
- stimulates business investment, reducing dollar demand.
Dovish rate policy suppresses dollar strength.
- As the Fed pushes interest rates lower and lower, the demand for borrowing and lending increases. This creates more supply and less need for dollars.
- In reverse, as the Fed hikes rates, financial conditions tighten, growth slows, and the demand for dollars rises.
The PMI Growth Effect
Post-GFC, the peak-to-slowdown in manufacturing growth is correlated to a rising dollar.- As manufacturing growth decelerates in the real economy the demand for dollars rises.
- As conditions improve, growth returns, and the dollar weakens (cash is deployed into an investment).
Early 80’s Business Cycle
The fed hikes rates
- Growth peaks
- The dollar breaks out
1983
- The fed hikes again
- Growth peaks again
- The dollar continues to surge again.
1984
- the Fed cuts rates
- Growth stabilizes above 50
- The dollar collapses
Review
- Economic growth is a cyclical force impacting the dollar.
- Policy is a structural force influencing the dollar.
- The dollar is a macro force reacting to both cyclical and structural forces.
- The dollar can also disrupt markets, causing knock-on effects that influence policy.
The Denominator Effect | Equities
During a 4-year dollar rise, stocks had two +12-month bear markets. However, when the dollar collapsed, stocks exploded.
Stocks rise faster when the dollar is falling.
Post GFC, stocks corrected as the dollar rose sharply.
Review
Economic uncertainty and or global risk resulted in stock sell-offs. The dollar appreciated during these times, reinforcing both safe-haven & denominator effects.
The Denominator Effect | Commodities
Oil is the largest commodity on earth and the most significant component affecting energy prices.
The denominator effect ensures energy prices trade inverse to the dollar.
Copper is the most widely used metal for applications in the economy, making it a key variable for tracking inflation.
The dollar significantly impacts infrastructure prices
The Denominator effect | Crypto
Dollars are the primary currency flowing into Crypto. Naturally, as the dollar declines, the crypto space experiences significant growth.
The parabolic rise in Bitcoins history coincides with Dollar weakness...
...the same goes for Ethereum
Where will the dollar head next?
Consider the current macro conditions...
- Is economic growth slowing, steady, or accelerating?
- Are bond yields rising, falling, or steady?
- Are policy expectations hawkish or dovish?
- Is the dollar near, below, or above an important technical level?
Key Takeaways
- During economic shock, the dollar becomes a flight to safety and acts as a safe-haven during economic uncertainty.
Policy decisions & interest rates influence the dollar's price action.
- The denominator effect ensures that sharp price swings impact most assets, including stocks, bonds, commodities, and crypto.
A strong dollar tightens financial conditions, while a weak dollar eases financial conditions.