Dollar Strength & Interest Rates: How the Two Relate

For most of the 42 years since the US went off of the gold standard (that is decoupled the value of its currency from the price of gold), we have had a strong dollar. In other words, our money has been worth more relative to the currencies of other nations or regions. When the 2008 came, however, the dollar fell in value relative to other countries due to the fact that our downturn was steeper and quicker than most other countries. In fact, our dollar stayed relatively weak until about the middle of last year. Now, however, it is back with a vengeance.

This is due mainly to the fact that the US economy is performing better than most other parts of the world. So what does this mean to the average American? First, it reduces the price of gasoline. Since oil is priced in dollars worldwide, a strong dollar reduces the price of oil at home. Second, it makes travelling overseas less expensive, as the US dollar goes farther against weaker currencies. Finally, it reduces the cost of products manufactured in other countries and imported to the US.

A strong dollar also has its negative side. For investors, the most apparent negative effect is a slowdown in earnings growth due to the fact that US companies have to report all earnings in US dollars regardless of where they are, and they appear to lose money in foreign exchange conversion (although this is doesn’t really happen if the money stays outside of the US). It also cuts down on tourism in this country as it costs foreigners more to travel here. Finally, it makes it more expensive for companies in this country to sell products overseas as they have to raise prices in local currencies in order to receive the same amount in dollars.

Given the state of the world economy right now, the strong dollar is likely to be around for a while. This can be best seen in looking at interest rates. While the US is looking to raise rates, 24 other countries lowered their rates in the first quarter alone in an effort to boost their economies. As a result, the US is considered to have some of the higher rates (if you can consider the current rates as “high”) and people outside of the US are moving money here for the higher rates. Should the Federal Reserve go ahead and raise interest rates, the dollar would likely go even higher.

This is why I don’t expect interest rates to rise as quickly as many in the market are saying they will. While having a strong US dollar is good, having too strong a US dollar could slow or even halt the recovery in this country. At a time when other countries are lowering rates (several European countries now have rates less than zero), our rates already going up relative to the rest of the world, so why risk taking action and being blamed if it slows our economy. While interest rates may creep up from here, I don’t expect a meaningful move in the near term.

Similarly, the equity markets are not likely to do much. After basically being unchanged in the 1st quarter, the markets are likely to remain about flat with the possibility of a downturn as earnings growth has slowed this year (due in part to the foreign exchange concerns discussed above) and there isn’t a big impetus for stocks to increase from here.