A STRONG DOLLAR IN A WEAK ECONOMY?

Briefing

Introduction

Economies are the sum product of millions upon millions of individuals making choices, making products, buying and selling and planning and saving. They’re organized chaos on a national scale - constantly mutating lifeforms growing from cells of human desire and necessity.

In other words, economies are…weird.

Even the best, most decorated prognosticators fail to accurately predict what the American economy’s going to do in the near future, let alone what’s going to happen in the global economy. There are just too many variables, too much data, too many bizarre things that happen every day.

Take right now for example. The global economy is still trying to shake off a two-year hibernation due in large part to the pandemic. Inflation is rampant, supply chains are a mess, and the Federal Reserve has been jacking up interest rates like one of those rent-to-own stores after you miss a payment.

Yet somehow, the dollar is stronger than it’s been in 20 years…

Normally you’d think that a strong dollar would be a good thing, right? Strong dollar, strong economy, strong country. Strong is good, right? Well, apparently not for the stock market, as we’ve seen evidenced throughout the whole of 2022.

So what gives? How can the stock market be so weak when the dollar is so strong?

Wait, Currencies Have Power Levels?

Remember when you first found out about exchange rates, and that those rates can change based on supply and demand for money? What about when you learned that there are people whose whole job is buying and selling different kinds of currencies when their respective exchange rates change?

If you first learned all that today…sorry. And you’re welcome. Also there’s no Santa Clause, Easter Bunny, or tiny little men inside ATMs. It’s all computers.

Speaking of cash machines, the Federal Reserve is and has been one of the biggest factors in this whole dollar strong/market weak thing.

See, the Fed controls the money supply. If they want there to be more money, poof! There’s more money. If they want there to be less money, poof! Less money.

It’s a little more complicated than that, but that’s the gist of it. They can either buy or sell Treasury bonds—thus adding or removing money from the supply, respectively—they can make banks hold more or less of their money in reserve, or they can raise or lower interest rates. It gets way more complicated than that (fractional reserve banking, anyone?) but neither of us want this to turn into a lecture on the mechanics of monetary policy.

Instead, let’s talk about the ways the Fed has influenced inflation and the strength of the dollar.

 

Federal Reservations

Something weird happened back in the late Bush/early Obama years. It was called the Great Recession, and it was kind of a big deal.

The Federal Reserve, then led by Ben Bernanke, took some drastic steps to help the economy get back on its feet. They dropped interest rates lower than a crowd at a community college improv show, pumped as much money into the economy as possible, and it worked!

Kind of. 

The economy did end up getting its act together eventually, but all that interest-free lending and extra money in the system did more than just make the rich get way, WAY richer. Inflation hawks were screeching for years about the risks the Fed was taking with the economy, and interest rates stayed at rock-bottom well past the point of practicality.

And then another funny little thing happened in 2020. It was called COVID-19, and you may have heard of it.

The whole economy practically collapsed overnight. The government knew it had to do something, and that something was to authorize rescue packages worth trillions of dollars in aid. On top of that, the Fed—under Jerome Powell—went on a bond-buying spree. After the dust had settled, the M2 money supply had grown from $15.5 trillion to $21.6 trillion by early 2022.

Inflation is what happens when there are too many dollars chasing too few goods, or, in other words, when the supply of money is greater than the demand. So, in hindsight, the aftermath of the pandemic became a perfect storm - an oversupply of dollars due to the Fed’s monetary policy decisions plus a demand shock on a previously slumbering global supply chain.

 

But Wait, Shouldn’t Inflation Mean A Weaker Dollar?

The Fed’s tools for increasing the money supply and heating up the economy are the same as the ones they use for reducing the money supply and cooling things off. They’ve been pulling almost all the levers they can aside from raising reserve requirements, but the most important one is the one you’ve heard the most about in the news: Raising interest rates.

The Fed raised the federal funds rate at the fastest rate in recent history, going from near zero rates at the beginning of this year to around 3.83% as of November 2022. Higher interest rates make loans, mortgages, and other kinds of lending more expensive. That means fewer loans are made, which means less money is being added into the system.

Higher interest rates also make bonds more attractive to investors looking for consistent returns. International investors have been pouring money into Treasury bills—currently the safest investment in the world—and other dollar-denominated bonds to insulate themselves from even worse economic conditions in other developed countries.

See, you can’t buy dollar-denominated bonds in yen or pounds or euros. You have to buy them in dollars, which you can’t do unless you trade some of your country’s currency for dollars first.

Here’s the best part. Buying dollars drives up demand for dollars, and buying dollar-denominated bonds—particularly Treasuries—locks up those greenbacks in debt obligations for years or decades, effectively shrinking the overall number of dollars out there. And since the amount of goods on the market hasn’t changed, taking dollars out of the money supply has an anti-inflationary effect.

Actually, wait. Here’s the best part. You know how international investors are buying dollars and dollar-denominated debt because they perceive American investments as safer than the alternatives? That’s not because the American economy is doing particularly well right now. It’s because it’s doing less bad than other economies.

And people say economics is boring.

 

Uh, Neat. But What About The Stock Market?

The stock market is down because the stock market is down. You might think the strong dollar would help matters, but no. It does not. A strong dollar is good for importers, but multinational companies will find it harder to export things and will suffer a hit when they make euros/pounds/pesos/yen/etc that are suddenly worth less in dollars than they were a year ago.

So combine inflation with fears of a recession and sprinkle in some hits to exports and international revenues, and wallah! You’ve got yourself a bear market.

But wait, there’s more! Remember those interest rates everyone’s all excited about? Well guess what happens to companies that want to borrow money for investments and expansions when getting loans becomes a lot more expensive.

That’s right, that decline in corporate borrowing and spending is the cherry on top of this stock bear market sundae.

 

So There You Have It

To recap—because this is the sort of thing that demands a recap or at least a tl;dr—the dollar is strong and the market is weak for a few reasons.

Almost every major economy is having problems with slowing growth and inflation right now. America is just doing a bit better than other developed countries.

The Fed is raising interest rates, which decreases the money supply and slows down inflation.

International investors are buying dollars and spending them on American investments, especially Treasury bonds, driving up demand for (and price of) dollars while also decreasing the money supply.

All of that leads to a stronger dollar despite a weakened stock market and shuddering economy.

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