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Why you should keep an eye on the strengthening dollar

With most of the world’s financial transactions priced in US dollars, a strengthening dollar is not necessarily a good thing. But that’s exactly what we’ve got now, says John Stepek.

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A strengthening dollar is a bad sign for the markets

The US dollar is the world's reserve currency.

That's just a way of saying that it's the most important currency in the world. Most global financial transactions will involve dollars at some point in the process. Commodities are largely priced in dollars.

In short, everybody needs dollars.

So when they get more expensive, it's generally a bad sign for markets.

And that's what's happening just now.

It's tough at the top

The global financial system runs on dollars. At a very basic level, this in turn means that when the dollar is strong, global monetary policy is effectively getting tighter. If it's more expensive to get hold of dollars, then there's less money around for everything else. And on the flip side, if the dollar is weaker, then that means global monetary policy is looser.

This is a point that's worth remembering. All else being equal (and accepting that it rarely is), markets prefer a weaker dollar, because it indicates looser monetary policy.

This way of looking at things also makes it very clear that the Federal Reserve is exceptionally important. It's not just the US central bank. It's the central bank that has the most influence over one of the most important prices in the world the price of the global reserve currency.

Until very recently, the US dollar has been in retreat. That's taken many in the markets by surprise.

The US economy is strong. The Fed is raising interest rates. The new boss at the Fed is even seen as being a bit of a "hawk". So why has the dollar remained relatively weak?

The answer probably boils down to the fact that currencies more than any other market are a relative game. Markets have been believers in the "strong US" story for a while now. So they had plenty of time to price that into the dollar.

Since then, other areas have taken everyone by surprise. Japan has started to persuade investors that its recovery is finally for real. The eurozone has startled investors by demonstrating that its economy consists of more than just Germany. Even sentiment towards the UK has improved from the very depths of its post-Brexit angst.

Meanwhile, US president Donald Trump has committed to spending a lot more money, and borrowing a lot more money to do it. Overall, that should make the dollar weaker rather than stronger.

So in all, there have been lots of reasons why the dollar has been sliding since the start of 2017.

However, that might have started to change.

Why emerging markets don't like a stronger dollar

The US dollar index (which measures how the dollar is doing against a basket of the currencies of its trading partners), has been rallying in recent days.

What's behind the gains?

It's at least partly to do with the ten-year US Treasury yield hitting 3%. A 3% yield looks pretty appealing to lots of people in our current low interest rate world. If more people invest in US Treasuries from overseas, that increases demand for dollars.

There are various complexities with the high cost of hedging (if you buy a US Treasury from Japan, then if the yen gets stronger against the US dollar, you could lose your tasty 3% yield and more overnight, which is an expensive event to protect yourself against). But overall, higher yields should tempt more money into US assets.

So, more importantly, what does this mean for your investments?

To be very clear, there is no guarantee that this strength will continue. Again, a lot of this depends on how the market believes the Fed will react to economic data, and also how the economic data turns out (keep watching the employment data in particular).

While the market believes that the Fed will run a tighter monetary policy ahead of inflation, then you'd expect the bias to be for the dollar to rise. If the market starts to think that the Fed will allow inflation to have its head, then the dollar should tend more to the downside.

But it's worth keeping a close eye on. A higher US dollar has a knock-on effect on lots of things. Commodities are all priced in dollars (including gold). They don't always move in tandem, but a stronger dollar tends to mean lower commodity prices.

Emerging markets are particularly vulnerable to a stronger dollar. Firstly, their borrowing costs are often in dollars (though not always). So a stronger dollar makes it harder for emerging markets to service their debt.

Secondly, a stronger dollar tends to encourage money to "return home" to the US. That means "hot money" rushes out of the emerging markets, which can have a destabilising effect, based on how dependent the market happens to be on overseas money.

We're a long way away from an emerging market collapse. But it wouldn't be the first time in this bull market that the prospect of an emerging market blow-up has reared its head.

For now, this is just something to keep an eye on. The dollar is pretty weak just now anyway and the world can probably cope with a bit of a dollar rally (indeed Japan in particular would probably welcome it). But it's something we'll continue to monitor in our Saturday email on the "charts that matter".

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