The U.S. Dollar: It is Still King of the Currencies

The recent drop in the value of the U.S. dollar has been surprising. It is currently hovering around the lowest level in three years. As it stands, the dollar has declined about 10% from its recent high in mid-January. More than half of that decline has occurred since the day before “Liberation Day,” when President Trump announced planned tariffs. The decline is attributed mostly to the uncertainty of the on-again, off-again rollout of the tariffs.

The surprise is that the dollar fell in value because it runs counter to economic theory. A country that imposes a tariff usually has its currency increase in value. That's because the tariff reduces the demand for imported items, thus decreasing the demand for that foreign currency to pay for it.

The dollar's decline has drawbacks for consumers. Those who purchase goods that originated from overseas in part or in whole will now have to pay more for them. So if the U.S. dollar falls by 10%, basically the cost of those items will increase by about 10%. If there's a newly installed tariff of 10%, then the items will now be 20% more expensive.

Let's take a look at some charts for a better perspective on the recent move.

Chart 1, 1:30– In this first chart, the dark blue line represents the dollar's value, and the light blue shaded area represents the yearly percentage change.

On the right-hand side, you can see that the 10% decline has been relatively swift. But to put some perspective on that, we saw that same sort of movement as recently as 2022.

Chart 2, 1:53– This chart shows the price performance of the U.S. dollar and several other major currencies since the beginning of the year. As mentioned, the dollar has fallen in value, while most of the others have increased in value. China, in the middle of the chart, not so much. However, China's currency is not free floating like the others. The euro, the Japanese yen and the Swiss franc are viewed as safe havens, and they've experienced the most significant increase. This increase in the value of those currencies has implications for their countries’ economies.

Most notable is Switzerland, which has the smallest economy here, so the impact is greater. The higher the value of their currency, the cheaper their imports, and that should lead to lower inflation. However, their inflation is already very low with CPI at just three tenths of 1%. This may cause their central bank to cut their primary overnight rate from the current low level of just 25 basis points. This is not an enviable place in which to be.

Chart 3, 2:25– This is a longer-term view of the dollar's value going back to 1970. As you can see, the recent movement is pretty small compared to history. The dollar rallied in the 1980s, increasing by 78%. This is when Paul Volcker was the head of the Federal Reserve, and he increased interest rates on overnight money to as high as 20%. That was to stall economic growth so that inflation would fall to a reasonable levels. Interest rates at that level attracted a lot of foreign investment, causing the value of the dollar to move up significantly.

That increase in the value of the dollar caused an enormous trade imbalance. U.S. exports were very expensive, and the domestic producers found it difficult to sell their products overseas. The United States moved from a net exporter to a net importer of goods. In September of 1985, there was the Plaza Accord, which was signed at the Plaza Hotel in New York City. The G-5 nations, which consisted of the United States, Japan, West Germany, France and the UK, all agreed to devalue the dollar with a coordinated intervention in the currency markets.

It worked. In 1987, the Louvre Accord was signed, which aimed to halt the decline in the value of the U.S. dollar and stabilize the international currency markets.

There was another rally in the dollar brought on by the international excitement of investing in dot-com stocks.

Chart 4, 4:27– Another issue that comes up often in client meetings is the dollar's status as a primary reserve currency. Our view is that it is not something you need to worry about. You can see in the chart that there are several reserve currencies, but the U.S. dollar is clearly the premier reserve currency. You can also see that the U.S. dollar is the premier reserve currency by a long shot. It would be difficult and would take a long time to change that status. No other currency has a large and liquid market to handle the transactions needed to be the premier reserve currency.

Ever since the Bretton Woods Conference in 1944, which was held at a beautiful resort in Bretton Woods, New Hampshire, the U.S. dollar has been the dominant currency in global trade. The conference was held to prepare for the rebuilding of the post-World War II global economic system and to establish and regulate an international monetary system. It needed a single currency on which to base global transactions. The easy answer was that the U.S. dollar was the best.

The United States was the dominant economic power at the time, accounting for about 50% of global GDP. It also had the world's largest gold reserves. The dollar was backed by gold, and the value of the dollar was fixed at $35 an ounce. All 44 allies that attended the conference agreed to this.

Those were simpler times. It's gotten a little bit more complicated since then. In August 1971, President Nixon suspended the convertibility of U.S. dollars into gold. In March 1973, the dollar began freely floating.

Despite the turbulence in the foreign exchange market since Bretton Woods agreement, the U.S. dollar has remained the premier reserve currency. This is because it is the most stable and liquid form of exchange, and the currency can be freely used or exchanged for one another inside or outside the borders, which is essential for global trade. The world’s trust in the United States and its financial markets has resulted in the dollar remaining the linchpin of trade in the global economy.