Despite being the global reserve currency, the U.S. dollar has been a second-rate currency, trading in the doldrums. At least that was until last July when it began to show signs of life. Since then, the U.S. dollar index has risen more than 21%. But why is the U.S. dollar rising and is it sustainable?
Why the U.S. Dollar Is Rising: Strong U.S. Economy?
The U.S. Dollar Index, which measures the strength of the U.S. dollar against six world currencies, has been on the rise since last summer, climbing more than 20%. If the only measure of the U.S. economy you had at your disposal was the U.S. dollar index, you’d be forgiven for believing the U.S. economy is on fire!
But the fact of the matter is that everything has to be taken in context, even the rising U.S. dollar. The U.S. economy continues to be precarious. The only reason it looks so strong is because it’s compared to global economies that are hurting so much.
For starters, the U.S. Dollar Index is made up of six different currencies: the euro, Japanese yen, British pound, Canadian dollar, Swiss franc, and the Swedish krona. Not all currencies are created equal; each of the global currencies in the U.S. Dollar Index is weighted differently.
For example, the majority of the calculation is based on the euro, which makes up 57.6% of the index, followed by the Japanese yen at 13.6% and the British pound at 11.9%. These three currencies comprise 83.1% of the index.
This might just help explain why the U.S. dollar has been, in part, performing so well over the last eight months. It’s not that the U.S. economy is on fire, it’s that Japan, the eurozone, and British economies (you can also toss in China and Russia) are doing so poorly.
Will the U.S. Dollar Keep Rising?
What are some other factors affecting the dollar’s value? One of the biggest players in determining if the U.S. dollar will rise has been the Federal Reserve, the puppet master.
To help kick-start the crippled U.S. economy back in 2008, the Federal Reserve initiated its first of three rounds of quantitative easing (QE), reducing the target federal funds rate from 5.25% to virtually zero. At the start of 2008, before the generous bond-buying program started, the Federal Reserve had a balance sheet of $930 billion. When it ended in October 2014, it had ballooned to $4.5 trillion. (Source: Federal Reserve, October 31, 2014.)
The Federal Reserve basically started to wind down QE when it thought the U.S. economy was getting stronger. When the bankers in charge of the world’s biggest economy say things are getting better (even if it they aren’t), the investing community listens. And people started to pour even more of their money into the safe haven that is the United States.
On its own, the U.S. economy remains fragile. As a result, the U.S. dollar is on unstable ground and may not be able to sustain the unprecedented rise. Unemployment may be down, but most of the new jobs seem to be coming from low-paying sectors like retail and restaurants/services. The underemployment rate has remained above 11% since September 2008.
In March, U.S. employers added the fewest jobs in more than a year. Non-farm payrolls rose 126,000 in March, less than half of February’s pace and the smallest gain since December 2013. (Source: Bureau of Labor Statistics, April 3, 2015.)
It also doesn’t help that the U.S. economy is being hindered by growing inequality, stagnant wage growth, and a vanishing middle class.
Rising U.S. Dollar Hurts Economic Growth
Additionally, the U.S. dollar could face short-term headwinds if the Federal Reserve hints that U.S.-specific economic data points to a slowing economy. This is because, in part, a strong, rising U.S. dollar will hurt U.S. economic growth.
A stronger U.S. dollar points to increased consumer spending here at home. That’s good! At the same time, companies that do business outside the U.S. (which is the majority of brands) will see their earnings hammered by brutal currency devaluations. This has been happening for the last few quarters.
A rising U.S. dollar means foreign countries could increase their imports from less expensive producers like China. Countries looking to avoid dealing with a rising U.S. dollar could trade amongst their peers; for example, BRICS countries could lend each other a helping hand.
Near-Term Outlook for the U.S. Dollar
That said, fears of a U.S. dollar collapse are overblown—at least for now. That doesn’t mean the U.S. dollar isn’t on fragile ground; it is and it won’t be able to sustain its current pace forever.
But until the Federal Reserve lets go of the puppet strings and the global economy rebounds, tepid growth in the U.S. economy will continue to outpace the rest of the developed world and the U.S. dollar will reign supreme.