The Resilient Dollar: Why the US Currency is Holding Strong

20th December 2020

Despite the tumultuous year of 2020, the US dollar remains a strong global currency. This article delves into the factors behind its resilience and what this means for global markets.

In the face of a global pandemic, economic downturns, and unprecedented monetary policies, one might expect the US dollar to show signs of significant weakness. Yet, as we close out 2020, the US dollar remains remarkably resilient. This enduring strength raises the question: what are the underlying forces at play, and what does this mean for global markets?

The US dollar has long been the world's dominant reserve currency, a status it has held for decades. The dollar's strength during times of crisis, such as the one we find ourselves in with the COVID-19 pandemic, might seem counterintuitive. After all, with widespread economic shutdowns and the US Federal Reserve slashing interest rates to near-zero, one might expect the dollar to suffer, especially in comparison to other major currencies. However, the dollar’s performance remains robust, and it continues to be the safe haven for investors around the globe.

One key factor in the dollar’s resilience is its role as the world’s primary reserve currency. The dollar is used for the vast majority of global trade, and it is the preferred currency for international transactions, commodities, and foreign exchange reserves. This global demand ensures that the dollar maintains its strength, even when domestic conditions might suggest otherwise. When markets face turmoil, investors tend to flock to the dollar because it is perceived as a stable store of value. The Federal Reserve’s actions, though expansive, have not been enough to shake the fundamental confidence in the US currency.

Another important factor is the size and diversity of the US economy. The US is not only a major consumer of goods and services but also a significant producer, with a well-developed industrial base and cutting-edge technological sectors. This economic diversity means that, while some sectors may be hit harder by global events like the pandemic, others remain relatively unscathed, contributing to the overall strength of the dollar. Moreover, the United States’ financial system is deeply interconnected with global markets, and this integration further bolsters the demand for the dollar, particularly in times of crisis.

Furthermore, the Federal Reserve’s swift and aggressive actions to support the economy during the pandemic have played a crucial role in maintaining the dollar’s strength. In response to the pandemic, the Fed slashed interest rates and initiated a massive programme of quantitative easing. These measures were intended to inject liquidity into the economy and support financial markets, but they also had the effect of ensuring the continued availability of dollars in global markets. Despite these expansive policies, the dollar’s role as the world’s reserve currency has remained largely intact.

In addition to these factors, the dollar’s resilience can be attributed to the relative strength of the US financial markets. The US stock market, despite significant volatility during the early months of the pandemic, has rebounded strongly, with major indices such as the S&P 500 reaching new highs in the latter part of the year. This recovery has helped reinforce investor confidence in the US economy and, by extension, in the dollar. The US also continues to benefit from the deep liquidity and transparency of its financial markets, making it an attractive destination for foreign investment.

Another crucial element contributing to the dollar’s resilience is the relatively weak performance of other major currencies, particularly the euro and the Japanese yen. While central banks in these regions have also taken aggressive monetary actions in response to the pandemic, their economic fundamentals are not as strong as those of the US. The European Union, for instance, has faced significant challenges in coordinating a unified response to the crisis, and its economy has been hampered by structural weaknesses and political divisions. Similarly, Japan’s economy has struggled with stagnation for years, and its currency has failed to inspire the same level of confidence as the dollar.

The dollar’s strength has implications for global markets, particularly in terms of trade and investment. For one, a strong dollar can make US exports more expensive for foreign buyers, potentially leading to a trade deficit. This is something that has been a concern for US policymakers for years, as a stronger dollar can hurt American manufacturers by making their goods less competitive on the global stage. However, the dollar’s strength can also benefit the US economy by making imports cheaper, which helps to keep inflation in check.

On the other hand, the dollar’s strength provides a significant advantage to foreign investors in US assets. For example, foreign investors can purchase US government bonds, stocks, and real estate at a relatively lower cost when the dollar is strong. This, in turn, supports demand for US assets and helps to keep interest rates low, further supporting the dollar.

The resilience of the US dollar also has broader implications for global financial markets. A strong dollar means that countries with significant US dollar-denominated debt will face higher servicing costs, particularly those in emerging markets. Many developing countries have taken on substantial amounts of dollar-denominated debt in recent years, and a stronger dollar makes it more expensive for them to repay these loans. As a result, a prolonged period of dollar strength could lead to financial strain in certain parts of the world.

Moreover, the dollar’s strength could influence the trajectory of global inflation. As the US dollar appreciates, it can lead to a decrease in commodity prices, which are typically priced in dollars. For example, oil prices are often inversely correlated with the strength of the dollar: when the dollar strengthens, oil becomes more expensive in other currencies, reducing demand and putting downward pressure on prices. This dynamic has important implications for global inflation, as falling commodity prices can help to keep inflationary pressures in check.

Despite the resilience of the dollar in 2020, there are reasons to believe that its dominance may be challenged in the future. The rise of alternative currencies, such as the euro, the Chinese yuan, and even digital currencies, presents a potential threat to the dollar’s status as the world’s reserve currency. However, these alternatives face significant hurdles. The euro, for example, has struggled to gain widespread acceptance outside the European Union, and the Chinese yuan is still subject to capital controls and political restrictions. As for digital currencies, their volatility and lack of regulatory oversight make them unlikely to pose a serious challenge to the dollar in the near term.

One cannot help but think of the dollar’s resilience in a literary sense, akin to the character of Odysseus in Homer’s The Odyssey. Odysseus, faced with endless trials and tribulations, demonstrates an extraordinary ability to adapt, survive, and return home. Similarly, the US dollar has endured various challenges, from wars to financial crises to the current global pandemic, and it continues to prove its resilience. The dollar’s journey is one of survival and adaptation, and its ability to weather even the most turbulent storms suggests that it may continue to reign supreme for years to come.

In conclusion, the resilience of the US dollar in 2020 can be attributed to a combination of factors: its status as the world’s reserve currency, the strength of the US economy, the actions of the Federal Reserve, and the relative weakness of other major currencies. While there are challenges to the dollar’s dominance, it remains a cornerstone of the global financial system, and its strength is likely to persist in the near future. For global markets, the dollar’s enduring resilience provides both stability and challenges, and its performance will continue to be a key factor in shaping the economic landscape in the years to come.