US dollar strength has been a feature of global markets this year. Year-to-date, the dollar index has, gained from 95.67 to 109.97. This is an increase of 14.94%. The index tracks the strength of the dollar against a basket of major currencies. The index was developed by the Federal Reserve in 1973 and despite representing the world’s reserve currency has shown substantial volatility over the years. It peaked in 1985 at 160.41 due to severe monetary tightening as the Fed sought to slay the inflation dragon. Then, recognition that excessive dollar strength was destabilising for the world economy resulted in the Plaza Accord in September 1985, when leaders of the G5 group of nations agreed to coordinate efforts to weaken the currency. The dollar had strengthened by 50% over the preceding 5 years but by December 1987 the dollar index had retraced all the way back to 85.42 and years later hit a record low of 71.74 in March 2008 in the middle of the US sub-prime crisis.

The dollar gyrates according to economic cycles, interest rate differentials and capital flows. Against the euro, the dollar hit $/€1.57 in March 2008 compared with $/€0.84 in May 2001 and $/€0.99 today. The pound bought $2.41 back in 1980 but by February 1985 the dollar had appreciated to £/$1.08 only to weaken again to £/$2.05 ahead of the sub-prime crisis in December 2007.

What is powering the dollar today? It is the US economy, which helped by its energy self-sufficiency, is expected to escape recession. By contrast the energy supply shock stemming from the Ukraine war is wreaking havoc on other economies, especially in Europe and the UK, while China’s property market is entering a deep depression.

Interest rate differentials are also at work. The Fed is sounding increasingly hawkish and committed to beating inflation at whatever the cost, whereas other central banks are more circumspect due to the enormous burden being placed by energy prices on households and businesses. Gas prices in Europe have increased more than tenfold compared with immediate pre-pandemic levels. The level of energy costs as a share of US GDP is currently 5.8% whereas in Europe it is 18.3%. With the BOE less willing to do “whatever it takes” to beat inflation and with surging energy prices, Goldman Sachs predicts UK inflation could exceed 22% in 2023. The ECB will face similar pressure to dial back its inflation fighting policy measures. As a result, interest rate differentials with the US will widen.

Europe and the UK are in danger of severe energy supply disruptions in coming months. The answer to this is additional fiscal stimulus. Newly elected British Prime Minister Liz Truss has pledged tax relief worth £130 billion, which would exceed Covid furlough scheme support. Added pressure on the fiscus will further undermine the attraction of European and UK government debt. During August, the yield on the 10-year UK gilt increased surged from 1.81% to 2.88% amid wholesale selling by foreign investors. Where did these investors flee? Probably to the greenback.

Unless a global crisis is home grown as it was in 2008 with the US sub-prime crisis and Lehman Brothers bankruptcy, any hint of a global recession causes the dollar to strengthen amid a flight to safety. Investors flock to the world’s reserve currency in troubled times. The world is in trouble. Besides surging inflation and an energy supply shock, there is a war in Europe and tensions are rising between China and the West.

Emerging market currencies tend to suffer the brunt of any currency volatility especially those affected by substantial dollar denominated debt. However, developed currencies are also vulnerable. As Europe enters a deep energy induced recession, the spotlight will once again fall on the weaker members of the eurozone. The ECB will be under pressure to shore up the Italian sovereign bond market, which will require bond purchases rather than a reduction of its balance sheet. The pound is particularly vulnerable due to its burgeoning public debt but also its widening current account deficit, which in the first quarter of this year surged to a record 8.3% of GDP. The rapid increase in imported fuel costs is the main culprit. Under the Truss leadership, not only will the British fiscus deteriorate but relations with the EU are also likely to sour further.

Whereas the ECB may be forced to continue quantitative easing to protect eurozone solidarity the Fed is on track to accelerate the pace of its Quantitative Tightening programme with the aim of reducing its balance sheet from $9 trillion to $6.5 trillion. The price of the dollar is bound to appreciate further as the actions of the Fed and other central banks diverge and the pool of global dollar liquidity continues to shrink. Capital Economics forecasts the euro will weaken to $0.90 and the pound to $1.05 but some economists believe further depreciation is inevitable with the pound likely to reach parity with the dollar.

Divergence in economic growth, interest rate differentials, capital flows and dollar liquidity should continue to support dollar appreciation, but the currency’s strength could be a double-edged sword. A strong dollar will certainly benefit savers and Americans buying properties in Europe, but it may not be good news for US equity markets. The US will lose export competitiveness and overseas earnings will be worth less in dollar terms, whereas equity markets in the UK and Europe, already at their biggest discounts to US markets in decades, will receive a substantial boost from their more competitive currency valuations. A strong dollar will be a handbrake on US equity markets, but it will assist in lowering imported inflation, which for the time being is the Fed’s overarching priority. Hence it is unlikely there will be another Plaza Accord anytime soon.