Since May 2021 the US dollar has posted a 14% gain against a broad basket of currencies. It now stands near its highest levels in decades versus major currencies like the euro, the British pound, and the Japanese yen. This sharp rise prompts a question: what is driving the rise?
Due to the Federal Reserve's aggressive pace of rate hikes, yields on U.S. Treasuries are now significantly higher than in most G-7 countries, apart from a few commodity-producing countries. For comparison (week to September 9): US Treasury 10-year bond - 3,29%; Germany - 1,74; UK -3.15%; Japan - 0,26%, the gap between US short-term bond yields and yields in other countries will widen.
Fed's tightening policy is particularly damaging for emerging-market countries. Many EM countries and companies in these countries issued dollar-denominated debt over the past few years when borrowing costs were low, and investors could afford to take risks to get higher returns. Trying to service that debt with a weaker currency at higher interest rates today puts more pressure on the issuers causing them to downgrade or default.
Capital outflows depreciated EM currencies causing EM central banks to raise interest rates to curb the outflows, which resulted in weaker growth. No wonder, EM bonds—both U.S dollar (USD)-denominated and local currency bonds — have produced sharply negative returns in the fixed income market over the past year.
A strong dollar helps suppress domestic inflation, by lowering the cost of imported goods.
Amidst a rising dollar and high U.S. interest rates, global portfolio diversification becomes challenging for investors. The yield-to-worst on the Bloomberg Global Aggregate ex US Index is only 1.84% with a duration of 7.6, as opposed to a yield of 3.42% for the U.S. Aggregate Bond Index (Agg) with a duration of 6.3.
Taking into consideration the 14% increase in the dollar and the yield differential, according to Bloomberg estimates, the broad international index has dropped 18% over the past year, - about twice that of the U.S. index.