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What Happens When The U.S. Dollar Declines?

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by: CME Group
Summary

If the greenback declines, the benefits can be widespread.

Over 80 percent of all currency transactions involve the greenback, and investors of all asset classes have learned that its ups and downs can have significant ramifications for their investments.

Any businesses with customers outside of their own borders need to be mindful of its swings, because the moves in the greenback can have a big impact on earnings and equity valuations.

By Kathy Lien

At a Glance

  • Gold and oil often rise; earnings tend to surprise more when the dollar falls.
  • In a booming economy, a declining dollar can be a positive contributor to growth.

The U.S. dollar is the most important currency in the world, and when it falls, everyone feels the ripples. Over 80 percent of all currency transactions involve the greenback and investors of all asset classes have learned that its ups and downs can have significant ramifications for their investments.

But the dollar’s influence is even more far-reaching than that - any businesses with customers outside of their own borders need to be mindful of its swings, because the moves in the greenback can have a big impact on earnings and equity valuations.

Dollar Connection to Gold and Oil

In fact, it is hard to find a market that is not impacted by the dollar’s fluctuations. If the greenback declines, the benefits can be widespread. Commodities like oil and gold are priced in dollars so when the dollar falls, oil and gold prices are pushed higher. This drives up prices and, by extension, inflationary pressures. Back in 2017, when the U.S. dollar index dropped 13 percent, oil prices rose nearly 7 percent from their bottom and gold prices rose more than 15 percent before giving back their gains.

However, the correlation is not perfect, because gold can rise contemporaneously with the U.S. dollar in times of risk aversion when markets are selling off and investors are nervous. We saw that in the last quarter of 2018, when trade tensions caused the Dollar Index to rise 2 percent and gold to increase 6 percent. Oil can rise alongside the dollar if there is a supply shock or problems unique to oil-producing nations.

Effect on Earnings

Stocks are also extremely sensitive to the dollar’s movements, because these days almost every company either sources from other countries or sell their products abroad. Here in the U.S., when the dollar falls, we tend to see more earnings surprises than disappointments for two reasons: foreign consumers buy more, and foreign earnings are worth more when translated back into U.S. dollars.

All of this contributes positively to growth, leading to a broader rally in stocks and, oftentimes, commodities. Companies in the energy and metal sectors are even bigger winners with the dollar falling and commodity prices rising. As a rule of thumb, U.S. equity investors tend to like a falling dollar and not a rising one, because a strong dollar can lead to a string of earnings disappointments.

Treasury Prices

Even the bond markets are affected, but in messier ways. When the dollar falls, it makes U.S. Treasury investments less expensive, but the specific impact on prices depends on the phase of the economy. If the economy is slowing, the weaker dollar provides stimulus, assisting the Federal Reserve in its efforts to boost the economy. This is generally positive for the prices of Treasuries. If the economy is booming in a high inflation environment, a weaker currency can add to existing price pressures, increasing the need for monetary tightening, which can drive Treasury prices lower.

So, if we are in an environment where the dollar is falling or at the cusp of a big sell-off, investors can expect that the move will provide much-needed support to the equity and commodity market. If the global economy is slowing at the same time, it will help to ease the pain for businesses, particularly in the energy sector. In contrast, if the global economy is booming, a falling dollar will be a positive contributor to U.S. growth, giving central banks a stronger reason to raise interest rates.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.