Dollar Denomination
The Significance of the US Dollar in Global Markets
The US dollar (USD) is not just a currency; it’s a barometer of the global economy’s health and a pivotal player in the international financial landscape. Its importance stems from several key factors. The USD serves as the world’s primary reserve currency, and central banks and financial institutions hold it globally to conduct international transactions and support their currencies. According to the International Monetary Fund (IMF), the US dollar comprises approximately 59% of the world’s allocated foreign exchange reserves as of Q4 2020 (IMF, 2021).
Moreover, its role in global trade cements the dollar’s dominance. Commodities like oil, gold, and many others are priced in USD, making it the de facto currency for international trade. This status encourages countries to hold substantial USD to ensure smooth trade transactions. The Bretton Woods Agreement of 1944, which established the USD as the world’s primary reserve currency, laid the groundwork for this system, reinforcing the currency’s global significance.
Impact of a Strengthening US Dollar on Global Markets
A strengthening US dollar has far-reaching implications for global markets. When the USD appreciates, it can lead to tighter financial conditions globally. Emerging market economies, which often borrow in USD, find their debt servicing costs increasing as their local currencies depreciate against the dollar. This scenario can strain their economies and lead to reduced economic growth. Additionally, as the dollar strengthens, commodities priced in USD become more expensive for holders of other currencies, potentially leading to decreased demand and lower commodity prices.
Conversely, when the US Dollar appreciates, the value of a country’s foreign reserves increases when measured in their local currency. This dynamic is illustrated by the South Africa Gold and Foreign Exchange Contingency Reserve Account (GFECRA), which records unrealised gains and losses on transactions involving foreign currency reserves. This mechanism shields the South African Reserve Bank’s (SARB) income statement from fluctuations in currency values, as valuation losses are allocated to the National Treasury. A strengthening of the rand against the US dollar and other reserve currencies decreases the account’s balance, whereas a depreciation of the rand results in an increase.
The previous revision to the balances of this account was in 2003, resulting in a R28 billion unrealised gain for the central bank. Since that time, the value of the account has dramatically increased to R507.3 billion by January of this year, a surge attributed to the significant depreciation of the rand (Moonstone, 2024). The latest budget speech outlined the National Treasury’s intention to tap into the GFECRA, planning to utilise R150 billion to alleviate borrowing and wage expenses. This transaction aims to lower South Africa’s Debt to GDP ratio, which currently stands at 76%, and to offset the country’s projected borrowing costs of R385.9 billion for the year, equating to around R1 billion per day (Daily Investor,2023).
Historically, periods of significant USD strength have been associated with financial turmoil in emerging markets. For instance, the Latin American debt crisis in the 1980s and the Asian economic crisis in the late 1990s were exacerbated by strong USD conditions, highlighting the currency’s impact on global financial stability.
Understanding Inflation
Inflation represents the rate at which the general level of prices for goods and services is rising, signifying a decrease in purchasing power. It’s a critical economic indicator reflecting the health of an economy. While moderate inflation is a sign of a growing economy, high inflation can erode savings and diminish the standard of living. Economists measure inflation through various indices, with the Consumer Price Index (CPI) being the most widely recognised and the Personal Consumption Expenditures (PCE). The PCE measure is a comprehensive indicator of the total spending by individuals and households on goods and services in an economy. The PCE is significant because it accounts for a large portion of overall economic activity and is considered a key indicator of inflation. This measure is essential to economists and policymakers because it provides insights into consumer behaviour and the rate at which consumer goods and services prices change.
Historical data shows an inverse relationship between the USD’s strength and domestic inflation rates. For instance, during high inflation in the 1970s, the dollar weakened significantly against major currencies. Conversely, the strong dollar era of the mid-1980s was characterised by low inflation rates (Federal Reserve History, 2020).
The Federal Reserve is crucial in managing US inflation through monetary policy, primarily by adjusting interest rates. Higher interest rates can attract foreign capital, leading to a dollar appreciation as investors seek higher returns on dollar-denominated assets. Conversely, when the Fed lowers interest rates to combat low inflation or economic downturns, the dollar can weaken as investors look for better returns in other currencies.
In the USA, inflation has been on a downward trend after peaking at 9.1% in June 2022, the highest level since early 1980. This is well above their target inflation rate of 2%. Since March 2022, the U.S. central bank has escalated its policy interest rate by 525 basis points, reaching the current range of 5.25% to 5.50%. Officials from the Federal Reserve have communicated their cautious approach towards lowering borrowing costs and have conveyed that there is no immediate plan to initiate a reduction in borrowing rates.
Recent Overview:
In January 2024, there was a noticeable rise in U.S. prices. Yet, the annual inflation growth rate was the lowest in almost three years, leaving the possibility of a Federal Reserve interest rate cut in June open. However, many market participants expect rate cuts to start in the latter part of this year.
Over the 12 months leading up to January, PCE inflation climbed by 2.4%, marking the smallest year-over-year rise since February 2021. Core inflation, which excludes volatile food and energy prices, saw a year-on-year increase of 2.8% in January, the smallest gain since March 2021 (XM Global, 2024). Economists have pointed out that the government’s method for adjusting seasonal variations in the data might not fully account for early-year price increases. Most economists agree that these price hikes are unlikely to recur in February.
In summary, the US dollar is critical in the global economy, affecting international trade, investment patterns, and worldwide economic stability. The intricate relationship among US inflation, interest rates, and the strength of the US dollar has profound effects on global financial markets. Grasping these complex interactions is essential for investors, policymakers, and all stakeholders. As Wealth Managers, we recognise the importance of thoroughly understanding these interrelated factors and, therefore, adopt a proactive approach to manage our clients’ funds actively.
