Cross-Border

US Dollar Dominance: A blessing and a curse (Part II)

CalendarJanuary 29, 2024
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US Dollar Dominance:

A blessing and a curse (Part II)

In an earlier post, we explored how the US dollar’s centrality to the global financial system presents both a blessing and a curse for US businesses.

The blessing.

- Added convenience: simplified banking data requirements and wider acceptance of currency

- Easier access to capital; typically cheaper capital costs

The curse.

- Higher volatility, simply because the USD is so widely traded

- Potential for ‘hidden’ FX exposures

It can help your business’ bottom line to explore the dynamics of the USD and its position in the global marketplace. Using only USD can mask hidden FX exposures and can increase currency risk.

Knowing what you don’t know can be a good place to start. From there, you can make more informed decisions about your financial planning.


The why: The Dollar ‘Smile’ Theory

While it might seem counterintuitive, the USD is quite volatile compared to its peers in high-income markets like the EU, Japan, and Canada. The central role the USD plays in the structure of global finance drives this volatility. Stephen Jens’ ‘Dollar Smile Theory’ illustrates how USD fluctuations track to the ebbs and flows of global economic cycles. It can be a very useful framework for understanding what drives the value—and volatility—of the USD.

The Dollar Smile - How global economic cycles influences the US dollar

But US dollar dominance can be a double-edged sword. This emanates from macro-factors we will explore in two weeks’ time, but the bare fact is that that added convenience can come at a cost often not immediately apparent to US businesses operating across borders.

The ‘curse’ of US dollar dominance is that often businesses are exposed to hidden FX volatility, which is much more difficult to quantify.

Here is a summary of key observations.

1. In periods of economic weakness and risk aversion, the USD is strong:

  • US Treasury bonds are seen as the world’s most risk-free asset. Portfolio flows rush to Treasuries, pushing up the value of the USD.

  • Much of the world’s debt is priced in USD, especially emerging market government and corporate debt. When the economy slows and pessimism grows, businesses and governments seek to pay down debt rather than issue more. This is another flow that supports the USD.

2. As the global economy strengthens, risk appetite is heightened and USD weakens:

  • Higher-growth economies and higher-yielding assets in emerging markets become more compelling, and attract portfolio flows out of USD.

3. Late cyclical expansion results in a swing to US dollar strength:

  • US economy begins to outperform, achieving higher growth rates relative to other high-income market economies.

  • US assets, particularly the US equities market, receive foreign inflows as they begin to outperform global equities.

  • USD strengthens as inflationary pressure builds; Federal Reserve begins lifting interest rates to help keep the US economy from overheating, which starts the cycle all over again.

What does that mean for me?

The answer really depends on factors that are likely unique to your business and your industry.

The key takeaway is that the business cycle has a powerful impact on the value of the USD versus its counterparts. This is driven by factors far beyond the control of individual policy makers or market participants, but ultimately affects your business.

Hidden exposures can come from a number of standard practices:

  • Transactional risk, where subsidiaries price in USD but use their functional currencies in their accounting;

  • Translational risk, where assets are re-valued from the functional currency into USD for balance-sheet accounting; and

  • Margin risk, where imported goods and services may be priced higher as the vendor takes on the currency risk.

Identifying your areas of vulnerability, and uncovering those hidden exposures, can be enlightening. Knowing what you don’t know is the first step.

Corpay can help with insights tailored to your firm, your competitive environment, and to your business objectives. Our disciplined process and visualization tools can help you make more considered, and more confident, decisions about hedging and managing risk more strategically.

Those insights can be worth their weight in gold (or in USD, depending on your perspective).

Would you like to discuss this further? Let’s schedule a chat about how we can tailor the analysis to your business!

Please note: Opinions expressed in this article are those of the author. Please contact an independent advisor to ensure that solutions discussed here are right for your business. The hedging products described in this document can be useful but are also associated with significant added complexity; obtaining a thorough understanding of each such product's trade-offs/pros-and-cons (fully describing these is beyond the scope of this article) is important before choosing to use any of these products.

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Author

Sean Coakley, CFA

Sean Coakley, CFA

Director, Strategic Sales, & Market Strategist

Sean works with mid-market corporates, focusing on FX risk management and international working capital optimization. He blends experience in finance and capital markets with a robust understanding of business performance and capital markets knowledge.

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