A supercharged rally this year has brought the US dollar to the brink of yet another historic milestone: a pound-dollar parity. In other words, it's looking increasingly likely that 1 British pound could be worth just $1 for the first time in history as early as this year.

The pound's decline mirrors the fall in the euro, which had its tryst with dollar parity — a first in 20 years — not so long ago. The 23-year-old common currency has slid further as recession fears grow in the eurozone amid an energy crisis, largely fueled by the war in Ukraine.  

Other major currencies have also taken a beating. The Japanese yen has declined nearly 20% against the dollar this year, sliding to its lowest levels since 1998. The Indian rupee slid to a fresh record low on Monday after having breached 80 rupees per dollar for the first time earlier this year as global investors shun risky emerging market assets.

"The dollar is experiencing its largest valuation overshoot since the 1980s. Amidst extreme volatility, a global chorus of discomfort is slowly building," George Saravelos, Deutsche Bank's head of foreign exchange research, wrote in a note to clients.

Why is the dollar soaring?

The dollar's reputation as a safe haven in times of economic distress is a major factor. Recession worries, especially in the eurozone, have soared in the past weeks as elevated inflation, mainly driven by higher energy and food prices, forces central banks globally to tighten their money taps aggressively. The looming contraction is prompting investors to take refuge in the relative safety of the US dollar, which is less exposed to some of the big global risks right now.

The aggressive interest rate hikes by the US Federal Reserve is another reason. The central bank has been tightening its monetary policy at a frantic pace in a bid to bring down soaring inflation. The Fed's aggressive stance contrasts with those of the Japanese central bank, which has persisted with ultralow interest rates, and the European Central Bank which resisted steep rate hikes for the longest time. This has created a wide gap in interest rate levels in the US and the eurozone, causing investors chasing higher returns to move their money to the US.

The dollar's latest surge against the pound came after the UK government announced the biggest tax cuts in 50 years, with British Finance Minister Kwasi Kwarteng promising more tax cuts. The government's fiscal largesse has stoked concerns of an even more aggressive rate hike stance by the Bank of England.

"From our perspective, the UK's immediate challenge is not low growth. It is an extremely negative external balance picture reliant on foreign funding," Saravelos said. "The large fiscal spend just announced may boost growth a little in the short term. But the bigger question is this: Who will pay for it?"

What does a strong dollar mean for consumers?

A turbocharged dollar is adding to the woes of European households and companies, which are already contending with high costs. A weaker currency would make imports, which are primarily denominated in dollars, more expensive. When those items are raw materials or intermediate goods, their higher costs can further drive up local prices. For tourists traveling to the US, it means that their euros or pounds would be worth much less.

Normally, a weak currency is viewed as good news for exporters and export-heavy economies such as Germany because it boosts exports by making them cheaper in dollar terms. Amid global supply chain disruptions, sanctions and the war in Ukraine, that's unlikely to be much of a solace.  

For Indian consumers, too, the strong dollar is inflicting pain. India relies heavily on imports for crude and edible oils, which are priced in dollars and have become expensive in rupee terms.

Costly imports are further driving up inflation, prompting central banks to pursue an even more aggressive monetary policy stance as they look to tame demand. Higher interest rates would raise mortgage and other borrowing costs.

On the other hand, US consumers and businesses could see costs fall as imports become cheaper in dollar terms. For US travelers visiting Europe, their dollars would be worth a lot more. US companies that do a lot of their business abroad will be hurt as the profits they make in other countries will decrease in value in dollar terms.   

'A negative environment'

A strong dollar bodes trouble for emerging economies, particularly those that have a large amount of dollar-denominated debt, countries such as Turkey, Argentina and Ghana. An appreciating dollar could make the cost of servicing debt unsustainable in some of those countries.

"This is generally a negative environment for emerging markets, although vulnerabilities differ widely across countries," said William Jackson, chief emerging markets economist at Capital Economics. "The good news is that, in many of the large EMs [emerging markets], dollar debts are relatively small and currency moves haven't been particularly large. The risks are concentrated in frontier markets such as Sri Lanka (where these risks have already crystallized) and Ghana, as well as usual suspects like Argentina and Turkey," he wrote in a note.

For countries that rely heavily on imports, a strong dollar will add to inflation concerns. It will also erode their extremely crucial dollar reserves, making it difficult for them to pay for their imports.

When will the dollar surge end?

Saravelos says a "definitive peak" in US inflation risk which would prompt the Fed Reserve to slow down its aggressive tightening cycle is one "necessary condition" for the dollar rally to end.

He adds that more factors would be needed, including a peak in energy uncertainty in Europe and a shift away from zero-COVID in China, which continues to disrupt supply chains and aid the global slowdown.

"At least some of these need to happen to slow the unprecedented surge in safe-haven inflows into the US. We fear that none of these pieces are yet falling into place," he said.

Edited by: Hardy Graupner