1. What Drives the Dollar?
- Interest rate differentials: Higher U.S. yields attract foreign capital → dollar strengthens
- Growth differentials: U.S. growth outpacing Europe/Japan → dollar demand rises
- Risk appetite: Risk-off environment → flight to dollar safety
- Fed policy: Hawkish Fed (hiking) → dollar rallies; dovish Fed (cutting) → dollar weakens
- Trade flows: a large US trade deficit means dollars flow abroad, though foreign demand for US assets has usually offset it
Historical Examples
- • 2014-2016: DXY about 80 → 103 (+29%) as the Fed prepared to raise rates while the ECB and Bank of Japan eased
- • March 2020 to early 2021: DXY about 103 → 89 (-14%) after the Fed cut rates to zero
- • 2022: DXY 95 → 114 (+20%) as Fed hiked most aggressively since 1980s
2. Carry Trades
Investors borrow in a low-interest currency (such as the yen) and invest in a higher-interest one (such as the US dollar, Australian dollar or Brazilian real), earning the gap between the two rates. The risk is that the exchange rate moves against them and wipes out that gain.
Carry Trade Works When...
• Rate differentials stable or widening
• Low volatility environment
• Risk-on sentiment
• Example: borrow yen at 0%, hold dollars at 5% = about 5% a year, if the exchange rate doesn't move
Carry Trade Unwinds When...
• Risk-off shock (2008, 2020)
• Rate differentials compress
• Yen strengthens 10%+ in weeks
• Hedge funds forced to unwind → accelerates move
3. Dollar Impact on Asset Classes
Commodities (Inverse Correlation)
Commodities are priced in dollars, so a stronger dollar makes them dearer for buyers using other currencies, which tends to weigh on prices. The dollar also often strengthens when global growth slows, which hurts demand too.
Emerging Markets (Negative)
Many emerging-market companies and some governments borrow in dollars. A stronger dollar raises the cost of servicing that debt and tends to pull investment money back to the US. In 2022, as the dollar rallied, emerging-market shares fell about 20%.
U.S. Multinationals (Negative)
S&P 500 companies earn roughly 30–40% of their revenue abroad. A stronger dollar means those foreign sales are worth less when converted back, and large US companies regularly cite currency "headwinds" when it rallies.
Gold (Mixed)
A strong dollar has usually weighed on gold, which is priced in dollars. But in times of stress both can rise together as safe havens, so the relationship is unstable.
4. Currency Hedging
Many institutional investors hedge some of the currency risk on foreign assets. Whether hedging costs or earns money depends roughly on the gap between the two countries' interest rates: hedging into a higher-rate currency earns a little; hedging into a lower-rate one costs a little.
- Hedged international stocks: Removes currency volatility, but also removes currency gains
- Unhedged: Full currency exposure, higher volatility
- Example: eurozone shares rise 10% in euros, but the euro falls 5% against the dollar = about +4.5% for an unhedged US investor
How the Dollar Moves Other Markets
- Strong dollar: Has historically weighed on emerging markets and commodities, while US companies that sell mainly at home are less affected
- Weak dollar: Has historically supported emerging markets, international shares and commodities
- Widening rate differential (US yields rising faster than Europe's): Tends to strengthen the dollar, as money follows the higher yield
- Carry trade unwinds: A sharp rally in the yen, often alongside a jump in the VIX, has accompanied several risk-off shocks (August 2024 is a recent example)
- US multinationals with large overseas sales: A rising dollar shrinks the value of their foreign earnings when converted back into dollars
Bottom Line
The pattern: A strong dollar has tended to hurt commodities, emerging markets and US multinationals, and a weak dollar to help them. Currency moves change returns for any investor holding assets abroad, which is why professionals check it and beginners often overlook it.
Related
Educational content only. It describes how markets have behaved in the past and is not investment advice.