Download A Strong US Dollar Changes Everything

Schwab Center for Financial Research
A Strong U.S.
Dollar Changes
Everything
A white paper by
Kathy A. Jones,
Senior Vice President,
Chief Fixed Income Strategist
The U.S. dollar is near its highest level since 2003. We think
the dollar has entered a longer-term uptrend that could
continue. Factors behind the dollar’s advance include the
improving U.S. economic growth prospects relative to other
major countries and the shrinking U.S. trade gap. Also, the
monetary policies of the U.S. Federal Reserve and other
central banks are moving in opposite directions. Foreign
central banks have adopted policies to stimulate their
economies while the Fed is shifting toward tightening policy.
The strengthening dollar has important implications for
investors. In this wide-ranging interview, Kathy Jones shares
her investing outlook on the U.S. dollar and its effects on the
fixed income market.
Kathy A. Jones
Senior Vice President,
Chief Fixed Income Strategist
Schwab Center for Financial Research
Kathy A. Jones is responsible for credit
market and interest rate analysis, as well
as fixed income education for investors at
Schwab. Jones has studied global credit
markets extensively throughout her career
as a fixed income investment strategist,
working with both institutional and retail
clients.
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Executive Summary
• The U.S. dollar has appreciated by more than 20% on a trade-weighted basis
since last year. We believe the dollar is going to continue to move up longerterm.
• Improving U.S. economic growth, the diverging trend between U.S. monetary
policy and the policies of other central banks as well as the declining U.S.
current account deficit are factors driving the dollar higher.
• A stronger dollar has important investment implications. We suggest
reducing exposure to international developed-country bonds and emerging
market bonds and commodities.
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Could you describe the drivers for this idea?
There are many factors that influence the direction of a currency. In a freefloating currency system, demand for a currency is often driven by relative
economic strength, interest rate differentials and trade performance. Strong
economic growth usually means higher returns on investment and higher real
interest rates, which tend to make a currency attractive to hold. A country with
a trade and/or current account surplus will tend to have a stronger currency
than one with a deficit, all else being equal, because demand for the currency
will rise along with its surpluses. And since economic trends are often longerterm in nature, currency trends can last for years at a time. A final factor is
more difficult to quantify – the perceived safety of holding the currency.
When was the last time the U.S. dollar experienced
a long-term surge?
The U.S. dollar has seen two major bull markets in the post-Bretton Woods
era, which began in 1971 when the dollar’s ties to gold were severed. Each bull
market lasted for about six years. The first, from 1979 to 1985, saw the dollar
nearly double in value. A key driver in that bull market was high U.S. real
A key factor behind the
dollar’s recent strength
is the U.S. economy’s
interest rates. The Federal Reserve was fighting inflation and U.S. interest
performance
rates soared, attracting foreign capital to the U.S. markets. The bull market
compared with other
ended when an agreement between the world’s major trading partners – the
major countries.
Plaza Accord – was reached to bring the dollar back down.
The second major bull market, from 1995 to 2001, was driven in large part by
the technology boom in the U.S., which boosted economic growth and drew in
foreign investment to U.S. markets. When the tech bubble burst, the stock
market declined, interest rates dropped and foreign investment slowed, leading
to a weaker dollar.
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Why are you bullish on the U.S. dollar now?
In our opinion, a key driver behind the dollar’s recent strength is the
performance of the U.S. economy compared with other major countries. Over
the past year, the U.S. economy appears to be on firmer footing, while growth
remains slow elsewhere. The IMF estimates that the U.S. economy will expand
at a 3.0% pace in 2015 compared with 1.5% for the Eurozone and 1.0% for
Japan. Emerging market countries are also slowing down. The IMF estimates
GDP growth among this group to be 3% this year the lowest since the financial
crisis.
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With relatively stronger growth, U.S. interest rates – even at current paltry
levels – are significantly higher than those in core European countries or Japan,
making the dollar more attractive for investors to hold. Germany’s interest
rates are actually negative while Japan’s are stuck near zero. Even among the
other major developed countries, such as Canada and Australia, interest rates
are falling and look likely to remain low due to the slowdown in global economic
growth and falling commodity prices. Central banks in Europe and Japan are in
the midst of large quantitative easing programs to boost economic growth
which has depressed interest rates. China’s slowdown is weighing on the
currencies of countries with which it trades.
Wide interest rate differentials are often a key driver of currencies. Higher
interest rates make a currency attractive to hold for investors and difficult to
short among traders. For example, the trend in the euro/dollar recently has
tracked very closely with the short-term interest rate differential between the
U.S. and Germany, Europe’s largest economy.
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You mentioned that emerging market countries are
experiencing slower growth. How does this affect
the dollar’s valuation?
In recent years, emerging market countries have played an increasingly
important role in the dollar’s valuation. EM countries have expanded their
share of GDP and global trade, making them a bigger force in the currency
markets. And since the Asian currency crisis in the 1990s, many more EM
currencies are free-floating rather than pegged to the dollar. But slower growth
Slowdown in China’s
growth weighs on other
EM currencies.
in EM countries recently has weighed on those currencies versus the dollar as
well. To a large extent, the slowdown in China’s growth is a contributing factor
to the weakness in other EM currencies and some dollar-bloc currencies due to
their close trade ties. Countries that export raw materials to China such as
Brazil and Australia have seen their currencies fall steeply in the wake of
China’s slowing growth. The chart below shows the trend in the dollar versus an
index of mostly EM countries – described as “other important trading partners”.
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Can you explain the different paths the U.S. and
other countries are taking with their respective
monetary policies?
The divergence in growth prospects between the U.S. and much of the rest of
the world has global monetary policies heading in opposite directions. The U.S.
Federal Reserve has ended its bond-buying (quantitative easing) and is aiming
to raise interest rates perhaps sometime in 2015, although those plans are not
carved in stone. In contrast, other central banks are likely to keep short-term
interest rates low or even negative and have pursued expansive monetary
policies to boost growth.
Europe’s central bank plans to expand the bank’s balance sheet by as much as
1 trillion euros by September 2016. In Japan, the central bank’s balance sheet
is already at 60% of GDP and rising, while the U.S. Federal Reserve’s balance
sheet is at 25% of GDP. The UK is the only other major central bank to have
considered tighter monetary policy, but with inflation falling steeply it’s likely
that those plans will be postponed.
Is international trade an area of concern for the
dollar’s strength with global economic growth
slowing?
The U.S. is less dependent on exports to fuel growth than most other major
economies, which helps when growth outside the U.S. is slowing. Exports only
account for about 13% of overall GDP in the U.S., compared to 25% to 55% for
most other major G-7 countries. Since the U.S. runs a trade deficit it needs to
attract foreign capital because the balance of trade by definition has to
balance. Over the past few years, the boom in domestic oil production has
helped reduce the U.S. trade deficit. The U.S. current account deficit, which
includes trade and net earnings on foreign investments, has been shrinking
relative to the size of the economy. A decline in the current account deficit
reduces the need to import capital and is a positive for the dollar.
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If the dollar continues
Overall, we believe these factors will lead the U.S. dollar to trend higher over
the next year. If we are right, there are implications for investments.
to appreciate, the
return on foreign
bonds is likely to lag
What advice would you give investors if the dollar
does continue to rise?
behind the return on
U.S. bonds.
U.S. bonds will likely outperform foreign bonds from developed countries and
emerging markets. Currency appreciation or decline can be a significant factor
in determining the total return when investing in the international bond
markets. If the dollar continues to appreciate, then the return on foreign bonds
is likely to lag behind the return on U.S. bonds. This is especially true in the
developed country bonds, where yields tend to be lower than in the U.S. Even
among the countries with higher bond yields, such as Australia, the yield
spread versus U.S. bonds is relatively low compared to a year ago and may not
compensate for the risk of a further decline in the currency.
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Emerging market bond yields are higher than in developed countries, but EM
currencies tend to be more volatile and can have a bigger impact on the total
return of a bond investment. Moreover, we believe the exposure of many EM
countries to a global slowdown is higher than it is for the U.S. While every
country is different, on average EM countries rely more heavily on exports as a
percent of GDP growth than does the U.S. Since the currency component of
total returns in EM bonds can be significant, they are likely to continue to
underperform U.S. bonds in a rising U.S. dollar environment.
Most EM countries have floating rate currencies
today as opposed to the case in the 1990s. How
does that impact this idea?
EM countries are better positioned today than in the past to withstand a
changing interest rate environment, but that flexibility is largely due to the
adoption of free-floating currencies over the past decade. The ability to let the
local currency decline when interest rate differentials widen vis-a-vis the U.S.,
can make it easier to repay the debt than if it were denominated in U.S. dollars.
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Are dollar-denominated EM bonds immune to
currency effects?
Even U.S. dollar-denominated EM bonds could underperform in this
environment. While the currency component is not as significant to total
returns as it is in developed country bonds, capital flows into EM countries
tend to decline when their currencies are falling. IMF studies indicate that
capital flows to EM countries tend to slow down within three to six quarters of
a U.S. rate increase and vice versa. From 2010 to 2013, capital flows to EM
countries increased by $1.1 trillion per year compared to an average pace of
$697 billion per year for the prior three years, according to the IMF. Since the
end of 2013, capital outflows from EM countries have increased sharply,
sending those currencies lower. With the Fed likely to raise rates next year, the
outflows are likely to continue.
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What are the risks involved with this investing idea?
While we believe reducing exposure to foreign bonds when the dollar is rising
makes sense, there are risks to consider.
• International bonds offer valuable diversification in an overall portfolio.
By reducing that exposure, an investor loses some of the benefits of
diversification.
• The path of the U.S. dollar is not certain. We could be wrong in our
expectations of a bull market for the dollar to continue. The Federal Reserve
might hold off longer on tightening monetary policy than current market
expectations suggest, which might result in a weaker dollar.
• Global growth might rebound more sharply than we anticipate, causing
currencies of countries that rely more heavily on exports and trade to rise
relative to the U.S. dollar.
• Expectations are for the Fed to begin tightening its monetary policy this
year, which could prompt a move higher in U.S. Treasury yields. Since bond
yields and prices move in opposite directions, this could lead to low, or even
negative, total returns for U.S. bondholders even if the dollar continues to
appreciate.
How will the bullish dollar affect commodity prices?
A strengthening U.S. dollar has contributed to the underperformance of
commodities as an asset class. Since most globally traded commodities are
traded in U.S. dollars, a stronger dollar tends to send the prices of
commodities lower, all else being equal.
Let’s look at an example:
Crude oil is globally traded and priced in U.S. dollars, which means if a
company in France imports oil from Saudi Arabia, it will need to pay for that oil
in U.S. dollars. That requires exchanging euros for dollars in order to conduct
the transaction. When Saudi Arabia receives payment in U.S. dollars, it needs
to either convert those dollars to its own currency, the riyal, or invest those
dollars in U.S. assets.
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If the dollar appreciates in value relative to the euro, then the cost of the oil will
increase by the same amount to the French company importing the oil. If the
dollar’s rise is broad-based against a large number of currencies, then the cost
of oil will rise for most or all importers. Consequently, in an efficient market,
the nominal price of oil will adjust lower to compensate for the change in the
dollar’s value. Or demand for oil might decline due to the rising cost, which in
turn would put downward pressure on oil prices.
Some commodities are more sensitive to the dollar’s changing value than
others, but all showed some correlation between the movements of the dollar
and movements in the prices of commodities. We looked at the relationship
between the dollar’s movement and the price index of four different commodity
groups over the past twenty years on a monthly basis. We found that precious
metals prices appeared to have the lowest correlation with the dollar’s
movement, while agricultural and energy prices had higher levels. The
R-squared readings in these four charts show how much of the movement in
the commodity price can be explained by the movement in the dollar. A higher
R-squared indicates a higher relationship and generally speaking, any reading
above .25 indicates that the relationship is statistically significant. When the
chart’s line is sloping downward it indicates that a lower dollar is related to
Commodity prices tend
higher commodity prices and vice versa.
to drop when the dollar
rises.
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What other factors are contributing to the
downtrend in commodity prices?
Prices have declined due to rising supplies of many goods - from oil to corn,
coupled with slowing demand due to faltering global growth. We expect these
trends to continue over the next year.
Strong global growth, spurred by China over the past decade, led to increasing
demand for basic commodities such as iron ore and oil. Consequently,
commodity prices rose steeply. Now increased supply has caught up with
demand. High prices led to big increases in investment in energy, agricultural
goods, industrial metals and precious metals worldwide. With the prospect of
large stockpiles of commodities and a slowdown in demand, prices have fallen.
A stronger dollar will most likely contribute to the decline in prices until supply
and demand are in balance.
There have been several such cycles in the commodity markets over the years,
but the recent cycle has seen the sharpest increase in prices in decades.
Based on the World Bank energy commodity index, the last time a move of this
magnitude occurred was in the 1970s. The index subsequently declined for
most of the next 20 years, after peaking in 1980. This cycle may be quite
different, but there is a case to be made that a decline in commodity prices
could last several years after such a substantial increase. A stronger dollar
could contribute to a longer and deeper decline.
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Important Disclosures
Past performance is no guarantee of future
results. Forecasts contained herein are
for illustrative purposes, may be based
upon proprietary research and are
developed through analysis of historical
public data.
The information here is for general
informational purposes only and should not
be considered an individualized
recommendation or personalized
investment advice. The type of securities
and investment strategies mentioned may
not be suitable for everyone. Each investor
needs to review a security transaction for
his or her own particular situation. Data
here is obtained from what are considered
reliable sources; however, its accuracy,
completeness, or reliability cannot be
guaranteed.
All expressions of opinion are subject to
change without notice in reaction to shifting
market, economic or geopolitical
conditions.
Indices are unmanaged; do not incur
management fees, costs, or expenses; and
cannot be invested in directly.
Fixed income securities are subject to
increased loss of principal during periods of
rising interest rates. Fixed-income
investments are subject to various other
risks including changes in credit quality,
market valuations, liquidity, prepayments,
early redemption, corporate events, tax
ramifications and other factors.
Investments in currency involve additional
special risks, such as credit risk and
interest rate fluctuations,
Commodity-related products, including
futures, carry a high level of risk and are not
suitable for all investors. Commodityrelated products may be extremely volatile,
illiquid and can be significantly affected by
underlying commodity prices, world events,
import controls, worldwide competition,
government regulations, and economic
conditions, regardless of the length of time
shares are held. Investments in commodityrelated products may subject the fund to
significantly greater volatility than
investments in traditional securities and
involve substantial risks, including risk of
loss of a significant portion of their
principal value.
International investments involve additional
risks, which include differences in financial
accounting standards, currency
fluctuations, geopolitical risk, foreign taxes
and regulations, and the potential for
illiquid markets. Investing in emerging
markets may accentuate these risks.
Barclays Emerging Markets USD Index
includes USD-denominated debt from
emerging markets in the following regions:
Americas, Europe, Middle East, Africa, and
Asia. As with other fixed income
benchmarks provided by Barclays, the
index is rules-based, allowing for an
unbiased view of the marketplace and easy
replicability. Barclays International:
Sovereign Index is a sub-index.
US Dollar Index (USDX) is an index (or
measure) of the value of the United States
dollar relative to a basket of foreign
currencies.
Index definitions
S&P GSCI® (formerly the Goldman Sachs
Commodity Index) serves as a benchmark
for investment in the commodity markets
and as a measure of commodity
performance over time. It is a tradable
index that is readily available to market
participants of the Chicago Mercantile
Exchange.
World Bank Energy Commodity Index is a
price index with fixed weights based on
2002-2004 average developing countries
export values, for coal, crude oil and
natural gas.
S&P GSCI® Agriculture Index, a sub-index
of the S&P GSCI®, provides investors with
a reliable and publicly available benchmark
for investment performance in the
agricultural commodity markets.
Trade Weighted U.S. Dollar Index: Other
Important Trading Partners is a an average
of the exchange rates of a country’s
currency with the currencies of its most
important trading partners, weighted to
reflect each trading partners’ importance to
the country’s trade. A currency’s trade
weighted index is also known as its
effective exchange rate. The currencies in
the U.S. dollar index are the euro, the yen,
sterling, the Canadian dollar, the Swedish
crown and the Swiss franc. It was launched
in 1973 with a value of 100.00.
S&P GSCI® Energy Index, a sub-index of
the S&P GSCI®, provides investors with a
reliable and publicly available benchmark
for investment performance in the energy
commodity market.
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1015-6057 (09/15) MKT83582-01 (10/15)
S&P GSCI® Precious Metals Index
provides investors with a reliable and
publicly available benchmark for investment
performance in the precious metals market.