There are a couple of things that we can reasonably expect in the coming months. First, a surge in small-cap stocks that will prove the bears wrong. Second, an impending downturn for investors in March. What could potentially be the catalyst for this downturn? If my analysis is correct, it will be none other than the U.S. dollar itself.

One could argue that the dollar’s strength is influenced by the Federal Reserve’s commitment to maintaining higher interest rates this year. As the Fed hints at a gradual tapering of the higher interest rates compared to countries experiencing more severe economic conditions than the U.S., investors will naturally gravitate towards the dollar, lured by the promise of greater returns on investments denominated in the currency.

The Risks Behind a Strong Dollar

What lies at the heart of this issue? Essentially, a robust dollar spells trouble for companies and nations holding debt in dollars.

A major concern stemming from a strong dollar in relation to foreign dollar-denominated debt is the heightened cost of servicing the debt. As the U.S. dollar strengthens against other currencies, borrowers holding foreign currencies must convert more of their domestic currency into dollars to meet their debt obligations, including interest and principal repayments. This surge in the expense of debt servicing, when measured in the local currency, can place significant financial strain on both sovereign and corporate borrowers. This strain amplifies the risk of default, especially in nations with limited financial flexibility or lower reserves of foreign exchange.

This situation can potentially lead to a sovereign debt crisis.

And when I examine the dollar chart, with recent strength challenging previous highs, it triggers a sense of unease within me.

A strengthening dollar escalates currency risk due to the heightened unpredictability and potential adverse effects of exchange rate fluctuations. This inherently discourages investment and complicates financial planning for both governments and businesses.

Furthermore, in a scenario of a strong dollar, the cost of refinancing existing debt increases as the expenses linked to issuing new debt to cover maturing obligations rise. This predicament can set off a vicious cycle of mounting debt burdens, particularly if the dollar continues to strengthen or maintains its strength over an extended period.

The Ultimate Impact

The broader economic ramifications of this cannot be overstated.

Elevated levels of foreign dollar-denominated debt, in combination with a robust U.S. dollar, can contribute to financial instability within a country and globally. It can trigger capital outflows, further devalue the local currency, and exacerbate inflationary pressures. In extreme instances, it might even induce financial crises, particularly in vulnerable economies.

It’s possible that we are approaching such an extreme scenario.

On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.