Why is the U.S. Dollar so strong? Can it continue? Complex narrative simplified.

United States is the world’s largest economy with GDP of 23 trillion USD and USD is the global reserve currency.

Risk-Free rate

The U.S. government has never defaulted on debt or missed a payment on debt and that makes US Treasury bonds risk-free investment. The interest rate paid by U.S government is considered as "risk- free rate".

Any other entity or government borrowing money from the open market will have to pay risk-free rate + risk premium to compensate for additional risk.

What is a reserve currency? Why USD? What are its perks?

The reserve currency is the currency of choice to execute international trade. Historically, the largest economy enjoyed the privilege of being the reserve currency.

Since 1450 there have been six major world reserve currency periods. Portugal (1450–1530), Spain (1530–1640), Netherlands (1640–1720), France (1720–1815), Great Britain (1815–1920), and the United States from 1921 to today. If you notice the average currency span is about 100 years.

Nearly all commodities such as oil, gas and food are quoted and paid in USD. Majority of global debt is also priced in USD. Central banks of all other nations and financial institutions around the world hold significant amount of U.S dollars to pay for trade and debt.

Whilst United States is shielded from FX volatility by virtue of being the reserve currency, it is a major risk for all other nations.

Why is the U.S. dollar so strong?

1.  Commodity prices especially oil, gas and food prices have surged after Russia invaded Ukraine. Not surprisingly, demand for US dollars is at all time high pushing up the value.

2.  U.S federal reserve is combating inflation by raising interest rates to bring demand in line with supply. So far this year, risk-free interest rate has increased from near zero to 3.25%.

3.  All other countries are forced keep pace with US rate rises or risk currency devaluation.  Major nations have let their currency devalue as aggressive rate hikes will tip economy into deep recession.

4. It is not easy for central banks; currency devaluation will trigger even higher inflation. Remember, all nations pay in USD to import oil, gas and food.

What next? How long will it continue?

1.  First, the federal reserve will have to signal the timing and the quantum of peak interest rate to the market, which in turn is dependent on US inflation and strength of US economy.

2.  Second, stable commodity price, unlikely until the Russia-Ukraine war end.

USD will continue to strengthen until there is certainty.

3.  Remote possibility but there is some sort of agreement between world’s major economies to depreciate US dollars to combat adverse impact similar to “Plaza Accord” in 1985.

To be continued....

Note: Views are personal and certainly not an investment advice. Article is oversimplified for educational purpose.

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