The Rise of the US Dollar
What it Means for Your Portfolio
Anti-dollar central bank policies have caused America's currency to be hammered for the past six years, but suddenly everything is coming up roses for the USD.
Where not long ago the dollar couldn’t get a break anywhere in the world, now the world is at its feet, lifting it higher and higher as investors flock to pay homage to it.
Currently measuring 85.5, the U.S. Dollar Index (DXY) comparing the value of the USD versus a basket of over a dozen foreign currencies is the strongest it has been since June of 2010, having soared 7% over the past three months alone while the S&P 500 stock index has fallen 3.5%.
Indications are the dollar will continue to strengthen, as foreign economies continue to reel and their central banks print more money to save them. The USD will not only benefit from foreign central banks knocking their own currencies down, but also from the U.S. central bank when it begins raising interest rates in the not too distant future.
But what does this newfound strength in America’s currency mean for our investment portfolios? As the dollar’s status shifts, should we be shifting our investments as well?
Why the Dollar is Rising
Before adjusting anything in our portfolios, we need to note why the dollar has been strengthening recently and whether this is a momentary phase or something more permanent.
For years since the end of the 2008 financial crisis, the USD had been under pressure by Federal Reserve policies aimed at flooding the U.S. economy with liquidity. Through three rounds of Quantitative Easing, more than $3.6 trillion have come gushing out of the U.S. central bank from mid-2008 until today. The graph below shows the effects these measures have had on the USD.
Sources: Macrotrends.net & BigCharts.com
• H2-2008 (yellow): In the midst of the raging financial storm, confidence in the U.S. economy and its dollar collapsed (lower graph). The Federal Reserve stepped in with the first round of Q.E. (upper graph), pumping out more than $1.3 trillion, raising its balance sheet from $0.9 trillion to $2.2 trillion.
At first, the USD strengthened on two accounts: first, the Fed’s involvement boosted confidence that the U.S. economy would be saved, and second, other economies around the world were being infected by the crisis, and their falling currencies lifted the dollar.
But by the Fed lowered interest rates to near zero by January of 2009, the USD had started falling again – just as the Fed had hoped, since a weaker USD meant more national income through exports, and cheaper capital for corporations and banks in America.
• H2-2009 to Q3-2010 (orange): For a while the USD continued falling thanks to low interest rates, which allowed the Fed slow its stimulus to a trickle. Though the USD had rebounded briefly in early 2010 amidst foreign currency concerns, low interest rates succeeded in bringing the USD back down.
• Q4-2010 to mid-2011 (pink): When the medicine from QE1 eventually started wearing off, the dollar started rising again in late 2010. Concerned that the recovery would stall, the Fed introduced a second round of QE, raising its balance sheet from $2.3 trillion to $2.9 trillion in less than a year. This helped push the USD down by mid-2011, which resulted in a credit rating downgrade by Standard & Poor's Ratings Services.
• Mid-2011 to mid-2012 (blue): Oddly enough, the downgrade didn’t hurt the USD at all. Instead, the dollar started rising again. Why? Because the Fed wasn’t pumping out very much stimulus anymore, holding its balance sheet flat for about a year. When the Fed turns its money taps off, the USD slowly starts creeping up.
• H2-2012 (green): So the Fed came out with its third and largest QE measure of all - monthly purchases of bonds and mortgages which have added a whopping $1.7 trillion to the Fed’s balance sheet from the fall of 2012 until now. The measure had the desired effect of pushing down the USD… at least for the remainder of 2012.
• H1-2013 (purple): But bleak economic reports out of China, Japan and Europe started to appear, making the USD the safest currency in which to be, causing it to rise yet again. The Fed stuck to its QE3 buying program to that by the end of April 2013 the dollar was once again stabilizing downward.
• Mid-2013 (inset): Suddenly, in a bizarre twist of events, the Fed casually revealed in a press conference its intent to “begin” reducing its QE3 monthly purchases by about the “end” of 2013. Being extremely fickle as they are, the markets jumped the gun and started pricing in the end of stimulus right then and there, in early May of 2013. During the first half of the month, currencies the world over started collapsing while the USD shot upward as per the inset.
• H2-2013 to Q1-2014 (brown): Immediately, several members of the Federal Reserve including Chairman Bernanke himself started reassuring the markets that QE3 was still ongoing and would not be stopped unless the economy could handle it.
It worked. As the uproar in U.S. bonds started calming down, so did the USD, falling once again under the weight of the continuing monthly bond purchases then still unchanged.
• Q2-2014 to present (gray): But things finally started changing for the USD for good at the start of this year, when the Fed began reducing its monthly asset purchases, slowing winding down its stimulus. It took a few months for the dollar to react, but by Q2 its rise had begun.
Now with QE3 almost at an end, the USD has nowhere to go but up. This will be followed in a year’s time by rising interest rates – slowly at first, but onward and upward none-the-less – giving the dollar even more momentum.
At the same time, Europe has announced stimulus measures of its own, driving the Euro and other European currencies down while lifting the USD up all the more.
It has been a remarkable roller coaster ride for the dollar since the financial crisis began 6 years ago. Every time it started to show signs of picking itself up, the Fed would hammer it back down to the ground.
Soon that hammering will stop, and there will be nothing holding the USD back from climbing higher. This will have implications for investors, causing us to re-evaluate our stock holdings.
Time to Think Domestic
For at least the next couple of years, then, less stimulus at home and more stimulus abroad means a shift in the types of companies that will outperform going forward.
All throughout this period of central bank stimulus since 2008, U.S. companies doing business abroad had a distinct advantage, as they received extra income through their exports when they converted their foreign profit into a cheap USD. Exporters were the stocks to hold, which the Fed wanted all along, boosting national income.
While the exporters were benefitting, importers and companies catering to the domestic market suffered, since the cheaper dollar meant they had to pay more for foreign goods.
Now, though, as the USD’s fortunes change, so will the fortunes of many U.S. companies. Now the exporters have the disadvantage. The dollar’s recent surge over the past few months has already caused U.S. companies engaged in foreign markets to lose a great deal of their profits through currency conversions.
As they sell their products and services in foreign countries, they collect local monies which need to be converted into USD when brought home to America. But as the USD grows more expensive to buy and foreign currencies keep sliding in value, a substantial portion of these foreign revenues are lost just through currency exchanges.
The advantage now shifts to the importers, as a stronger USD increases their buying power and results in lower prices for imported goods. Portfolios will thus begin a rotation as they lighten their weighting on U.S. exporters and increase their weighting of importers and domestic market players.
All in Moderation
Yet we should not completely divest ourselves of all foreign markets and exporters for two very good reasons.
First, the Fed still dislikes a strong dollar. If the dollar rises too fast, its sharp burst of buying power would cause prices to weaken, potentially turning an already feeble inflation into deflation, spelling disaster for Americans’ wealth in everything from stock portfolios to property ownership.
Thus, the Fed is going to keep a firm grip on its money tap. If it perceives the USD is rising faster than prices, the central bank could easily postpone interest rate hikes for a lot longer than anyone currently expects. This means that exporters, bonds, and other anti-dollar trades could still be viable for a while.
The second reason investors shouldn’t abruptly jump out of foreign markets all together is that after a recession it is the nations at the lower end of the scale that generally prosper the fastest. Just like small cap stocks are first out of the gate versus large cap stocks, so too with national economies, where small developing economies stand to rise the fastest during a recovery.
The International Monetary Fund recently revealed how emerging markets in Asia remain the most promising markets in the world. Comparing each global region’s risk of slipping into recession as noted below, the IMF found that emerging Asia stands almost no risk of recession at all, with just a 0.3% chance of it. Latin America and the U.S. stand a negligible risk of recession, while the Eurozone runs the greatest risk of shrinkage.
Now that the dollar’s rise has definitely begun and will continue for at least the next decade until interest rates return to their normal levels, and while several regions of the world are still under risk of recession, portfolios are due for a shift, with slightly less weighting in some overseas markets and a slightly greater weighting in domestic companies.
But the dollar’s rise will be closely watched by the Federal Reserve who is still keeping its hands on the interest rate and money tap. It is not in any hurry to unwind its enormous balance sheet now worth over $4.5 trillion. It will do whatever it takes to ensure prices rise just a little faster than the dollar, with inflation growing at a comfortable 2% to 2.5% range.
Investors must therefore be more selective now in this new era without stimulus than they have been for the last 6 years with stimulus. Emerging Asia, which includes China, are still very attractive places to be in, with Chinese growth still expected to average 7% per year.
In addition, we can now start turning back to the domestic U.S. market as well. The dollar is back!
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