The U.S. Dollar's Resilience: Strength or Illusion?

Since early 2020, the U.S. dollar defied economic expectations by appreciating against most of the world’s currencies. This trend is perplexing given the unprecedented rise in both national debt and the M2 money supply in the United States during this period.

This year, the U.S. national debt has surged to $35 trillion, marking a 50% increase since the start of 2020. Simultaneously, the M2 money supply has expanded by nearly 40%. These figures prompt a crucial question: has the dollar been genuinely strong, or has this perceived strength merely been an illusion?

According to basic monetarist theory, significant increases in debt and money supply should weaken a currency. With more dollars in circulation, each dollar theoretically holds less value, particularly when the supply of goods remains unchanged—leading to inflation. And indeed, inflation did rise.

The crux of the matter may lie in how we measure the dollar's strength. In finance, currency strength is often gauged relative to other global currencies, a critical concept that impacts global trade and interest rate policies.

In response to the economic fallout from the COVID-19 pandemic, most countries, including the U.S., adopted similar measures to stave off deflationary pressures: cutting interest rates and increasing deficit spending to bolster demand. Initially, the U.S. was particularly aggressive, reducing rates to near zero and enacting massive debt-fueled stimulus packages. As expected, the dollar depreciated by roughly 10% against major currencies, hitting a low around June 2021.

However, the narrative shifted in June 2021 when inflation emerged, signaling that the Federal Reserve would soon begin raising rates. Each month of delay heightened expectations of just how high rates could go. Beginning in February 2022, the Fed embarked on one of the most aggressive rate-hiking cycles in history, raising the federal funds rate from zero to 5.37% in just 18 months. U.S. rates soon outpaced those in most of the developed world. 

Recent comments by Fed Chair Jerome Powell have indicated that rate cuts are now imminent, which will likely shift global currency markets yet again.

Alongside the Fed rate-hiking cycle, FX volatility increased materially and CME Group FX futures quarterly average daily volumes reached record levels in Q3 2022, trading over one million contracts per day. While FX volatility has normalized in 2024, open interest in FX futures has continued to grow, reaching record levels of over 2.8 million contracts on June 14.