What to expect when you’re expecting a strong dollar
December 4, 2014
The broad implications of recent strength in the U.S. dollar have come into sharp focus for investors in all asset markets (not just currency markets). Dollar fluctuations can have major effects on many layers of investments, including equities, commodities, and fixed income assets. With the specter of continued dollar strength ahead (see Chart 1), it’s worth taking a look at how it has influenced asset prices in the past.
It’s also worth considering that the past may not be relevant to today’s particular cycle; in fact, when viewed in a certain light, the dollar might not be so strong at all. There is still a lot of game to be played, and the widely held expectation of dollar strength can be easily derailed given the interconnectedness of the global economy.
Chart 1. The path of the U.S. dollar
Data: Federal Reserve Bank of St. Louis. Monthly observations. Index definition is included in disclosures at end of commentary.
A brief look back in time
What does the past tell us about typical uptrends in the dollar? To begin with, commodities tend to perform relatively poorly during such periods, because most are traded and priced in dollars (see Chart 2). Dollar strengthening makes commodities more expensive around the world, and they therefore trade weakly as the dollar advances. (There are many other reasons for commodity softness, but we focus only on the dollar here.)
Chart 2. The U.S. dollar versus commodities: a mirror image
Data: Bloomberg. Quarterly observations. See disclosures at end of commentary for index definitions.
Second, a higher dollar historically suggests that U.S. equities should perform pretty well. This might seem counterintuitive at first, because one might suspect that U.S. stocks are priced in dollars and therefore become more expensive to international investors; but during strong-dollar cycles, U.S. growth is often robust enough that corporate earnings (and consequently stocks) rise together (see Chart 3).
Chart 3. The U.S. dollar and the S&P 500 Index
Data: Bloomberg. Quarterly observations. See disclosures at end of commentary for index definitions.
Finally, spreads on bonds rated below investment grade have a tendency to widen as the dollar advances. This may be due more to a rotation from fixed income into equity assets (due to healthier economic conditions), and less to credit deterioration.
A closer look at company-level implications
Some might say that the U.S. economic conditions necessary to generate a stronger dollar (stronger economic growth and favorable financing, among others) have also created favorable growth conditions for companies. But it’s also important to point out that while it might generally be seen as a positive for U.S. investment, a stronger dollar can be troublesome for companies who export their goods, because their products become more expensive to overseas buyers. As the dollar strengthens and foreign currencies weaken, goods paid for in foreign currencies are less valuable when converted back to U.S. dollars.
On the positive side, a stronger dollar, so long as it’s strong for the “right reasons,” could be good for many asset classes. U.S. equities, for instance, are typically unfazed by dollar strength. The caveat to this stronger dollar, however, is the strain it may place on economies elsewhere in the world. There is certainly a Catch-22 happening, given the structural changes to, and interconnectedness of, the global economy in the past decade.
It’s tough to draw conclusions about how the dollar should affect markets around the world if we are indeed in a longer-term dollar uptrend. Thinking broadly about the current cycle, some negatives might actually be positives, and vice versa. The following notes help explain the complexities in determining what a strong dollar might mean for international markets.
Potential benefits of dollar strength
In the case of robust growth in the U.S., the dollar would be strengthening for the “right reasons,” and this should be a boon to global growth. Equities would also potentially benefit from this growth despite the aforementioned knocks to earnings from currency effects.
The U.S. consumer could get a “tax break” on just about all commodities, in particular energy and gasoline. This could provide a boost to the consumer in the near future and help support U.S. consumption (which has been an engine of global growth in the past).
The Federal Reserve’s normalization of monetary policy could force other central banks to do some of the heavy lifting on monetary and fiscal easing. The argument would be that the dollar has created a deflationary downdraft for economies that import commodities. To the extent that this affects inflation in other countries, they may be forced to engage in unconventional monetary policy to force down their currencies and keep their economies from deflating, which would add to the next round of global liquidity. This is most notably true for Japan and Europe.
As commodity prices continue falling, it becomes more likely that emerging markets will resort to orthodox policy to bolster growth (as long as external balances remain in line). Consider that within emerging markets, food and fuel are major components of CPI baskets; lower commodity prices not only slow commodity producers' economies, they also put downward pressure on inflation components.
U.S. consumers will be able to buy more goods from abroad, further supporting the global economy due to dollar strength.
Potential pitfalls of dollar strength
A stronger dollar is pushing commodity prices downward, putting pressure on producers, which until recently were major engines of growth for the global economy. This is very problematic for countries like Russia.
The dollar is pushing inflation lower globally at a time when many countries are already dealing with near deflationary conditions. If this isn’t met with increasing central bank liquidity elsewhere, this could be a major black hole for the euro zone and Japanese economies, whose only source of inflation has recently been found in commodities.
A strong dollar is putting pressure on U.S. exporters and multinationals, particularly on revenue streams that are booked in currencies other than the dollar.
All else being equal, a rising dollar makes dollar liabilities rise in value, while reducing the value of revenues/earnings in foreign currencies. This mismatch can be problematic and is a variant of the so-called “original sin” concept. (In a financial sense, the idea of “original sin” applies to a situation in which a borrower uses domestic funds to borrow abroad.)
Forcing further unorthodox policy in Asia may in fact place more disinflationary pressure on the globe through the exporting of finished goods at lower relative prices due to currency adjustments.
Reading the signs is not always a perfect science
As suggested in the above lists, it’s anything but clear what a strong dollar might do in this cycle. Two basic questions: Will the dollar remain sustainably strong? Should it?
The dollar has had the tendency to move in alarmingly steady trends, often lasting five years or more. Many of the factors that lead to dollar strength are currently in place and we believe are likely to stay there (all else being equal). The biggest components are euro and yen weakness, which today’s markets are taking as a given. With that said, the dollar’s uptrend is unlikely to be very smooth because volatility should be on the rise in global markets.
What’s more, the chance for the Fed to blink in the face of economic weakness or a U.S. slowdown still looms on the horizon. The Fed may want to normalize policy, which would further encourage dollar strength as nominal rates rise, but global economies are still broadly weakening. The U.S. can certainly decouple from other economies for short periods of time, but the dollar’s influence might actually end up being the reason it can’t decouple for long.
There are many potential problems and benefits that come from dollar strength. The most important of the problems is global deflation. When you add further attempts by Asian businesses to export their own deflation, it becomes clear that escape from the Fed’s policy of zero interest rates might be very difficult indeed. This all suggests that dollar strength may actually be the one thing the Fed and global markets can’t tolerate. Anyone selling a certain strong dollar scenario today might actually just be selling dollars at the highs. Expect to be surprised.
The dollar feedback loop is a potential “Catch-22”
A look at the sequence of events that can potentially play out, and their repercussions in the U.S.
- The U.S. Federal Reserve starts on the path toward tighter monetary policy, sending the dollar higher and commodities lower.
- Europe and Japan weaken their currencies in order to keep pace with dollar strength/commodity weakness.
- Asian goods effectively become cheaper as their prices weaken.
- This weakness prompts further dollar strength.
- U.S. consumers benefit from falling prices, which seems good at first glance, but the U.S. could actually be immersed in a spate of potentially harmful deflation.
From here we could see a few things happen:
1. The deflation feedback loop continues and the Fed is forced to push dollar back down.
2. The U.S. consumer is so strong that U.S. growth picks up for a time (though eventually some of the benefits will accrue to other countries).
The key takeaway
Every time a major central bank weakens its currency, it typically strengthens the dollar and weakens commodities. What’s more, each time it pulls its currency lower, it forces another country into the mix. For example, if Europe weakens the euro, we typically see Poland's and Hungary’s currencies weaken right alongside it, on what we call “euro crosses.” This may force more slowing in these economies, because they might have to hike rates (or strengthen their currencies).
Read other comments from our investment teams on China and currencies:
The views expressed represent the Manager's assessment of the market environment as of November 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
The Trade Weighted U.S. Dollar Index (Major Currencies) represents the weighted average of the foreign exchange value of the U.S. dollar against a subset of currencies that circulate widely outside the country of issue. Major currencies represented in the index include those for the Euro Area, Canada, Japan, United Kingdom, Switzerland, Australia, and Sweden.
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