Economic Implications Of A Strong Greenback
The current situation in the US economy significantly supports for a strengthening greenback in the next months. First, the economy of the United States has mainly been strong relative to economic data from China, the eurozone and Japan. Next, the Federal Reserve is expected to increase interest rates in 2015, and US short and long-term interest rates will mean higher investor capital inflows. Furthermore, the US is achieving more energy independence due to shale energy production. This has a substantial effect in reducing the present account deficit of America, which in theory lessens the global supply of dollars and increases the price.
With the mentioned factors, it appears like the US dollar will continue on its bullish trend. For developed nations, the stronger greenback has often been beneficial, but for emerging market economies, this typically sparks fear.
Normally, the strong dollar is associated with a tightening in domestic economic conditions. In this case, we also have the advantageous impact of lower prices of oil that comes with the appreciation of the US currency.
There has also been a high correlation between movements in the greenback and movements in medium-term inflation expectations in the US, which have sharply declined in response to the stronger USD and dropping prices of commodities.
Lower prices of energy seem like a tax cut for businesses and households in the United States, increasing their real incomes. They also make it easier for the Federal Reserve to keep the interest rates lower for longer periods of time, and long rates are also distinctly possible to be weighed down by bond investors coming into the United States for better returns.
Considering all these factors, I think the strengthening of the greenback will ultimately have a positive effect on the economy of the US. Moreover, this suggests that its impact on US stocks is benign, though some sectors may possibly perform better than the others.
When it comes to the eurozone, the end result of a stronger US currency (and a weaker euro) will most likely be extremely positive, since it will help boost nominal GDP. The European Central Bank estimates that a 10 percent change in the currency leads to a 0.4 to 0.5 percentage point change in inflation. Hence, a weaker dollar has been acting against the ECB in the period of strengthening euro. Now, we might hope to see this situation in reverse, although the oil price declines might diminish this effect in the short-term.
For emerging market economies, which are at a remarkably different stage in their economic cycle than the developed ones, the macroeconomic effect of a stronger US dollar is more complicated. At initial glance, the dollar strength looks beneficial for emerging market economies too, since it gives them a competitive boost in US markets and delays the tightening of US monetary policy. However, the stronger greenback could also exacerbate inflation problems in some emerging market economies, and suck foreign capital out of these markets back to the United States. When this happens, it would result to severe volatility in markets and tough challenges for policy makers.
When it comes to the financial markets, the robust US currency tends to have an adverse effect on US equities in the short-term. In 2013, S&P 500 companies were holding an estimated $1.9 trillion in overseas investments. As the dollar becomes stronger, the value of these investments abroad is likely to erode.
On the other hand, the scenario of a weaker euro should be a considerable tailwind for European earnings, especially if it is coupled with the declining prices of oil. Therefore, this would definitely provide a highly needed boost to European equities, which have suffered from dropping earnings for the best part of 3 years.
All in all, a considerable strengthening of the greenback could lead to a bumpy ride for emerging market economies in the coming months or even years. But you should also take note that some emerging markets with economies that are linked to global supply economies are likely to perform better during this challenging period.