What Does the Dollar's Strength Mean for Investors?

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Key Points

    The dollar has jumped by 20% compared to other major currencies since last year, but we think there is more room for appreciation. The driving force behind the dollar's appreciation is the divergence between the Federal Reserve's monetary policy and the policies of other central banks. A strong dollar puts downward pressure on commodity prices, tends to keep inflation low and boosts the performance of U.S. assets relative to foreign investments.

The U.S. dollar is on a roll.

Last fall, we initiated an Investing Idea called A Strong U.S. Dollar Changes Everything. in which we suggested that the dollar was in the early stages of its third major bull market in modern history. Since the low in May 2014, it has appreciated by 20%. We think it has further to go.

The dollar is on the way up again

Note: U.S. Dollar Index (USDX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies.

Source: Bloomberg, daily data as of 7/20/2015.

The primary driver behind the dollar's appreciation is the relative strength of the U.S. economy compared to most other countries. Nearly six years since the end of the recession, the U.S. economy is approaching full employment, the threat of deflation has abated, and economic growth is gathering momentum. Consequently, the Federal Reserve is poised to hike interest rates this year. Stronger growth and higher interest rates tend to draw in foreign investors looking for higher returns, pushing the dollar higher.

In contrast, growth in many other G-7 countries is still below pre-recession levels and unemployment remains high. Spare capacity and very low inflation in these countries poses the risk that deflation could take hold. Central banks have made more than 50 interest-rate cuts so far this year, 1 and more are likely.

Europe and Japan are in the midst of large bond-buying programs (known as quantitative easing) designed to boost economic growth and counter deflationary pressures. As we've seen over the past six years, quantitative easing tends to drive down a country's currency as well as its short-term interest rates.

U.S. 2- and 10-year yields relative to other G-7 countries

10 major emerging-market currencies versus the U.S. dollar

Consequences of a strong dollar

Strong dollar takes its toll on commodity prices

Source: Bloomberg, weekly data as of 7/17/2015.

A stronger dollar can restrain inflation by depressing prices of imported goods, such as apparel and electronics—but not by as much as you would think. While lower commodity prices can help hold down inflation, consumer prices are also affected

by the cost of services and housing, which are less sensitive to the dollar's value.

Although the dollar's appreciation over the past year has been strong, the impact on growth to date has been modest and hasn't altered the Fed's plans to raise interest rates. Moreover, foreign investors have been increasing their investments in U.S. Treasuries and corporate bonds this year.

Still, by slowing growth and dampening inflation, a strong dollar can have an impact similar to a rate hike. For the Fed, it is considered one factor that "tightens monetary conditions." In her Congressional testimony on July 16, Fed Chair Janet Yellen indicated that the dollar's strength is something the Fed is taking into consideration and emphasized that rate hikes would be gradual. A strong dollar can mean lower interest rates longer term.

How far can the dollar go?

The prior two bull markets in the dollar ended when the currency's appreciation caused economic growth to slow and made U.S. investments less attractive. In the early 1980s, the dollar's rise had a devastating effect on the U.S. manufacturing sector. The United States came to an agreement with trading partners to drive the dollar lower. The deal was termed the "Plaza Accord," for the New York hotel where the meeting took place. In the late 1990s, the dollar bull market ended with the bursting of the tech bubble, which slowed the economy and made investing in the United States less attractive.

At some point, the dollar's strength is likely to be self-limiting, because it can cause a widening of the trade deficit and a decline in growth prospects as U.S. exports become less competitive. However, at 2.4% of GDP, the U.S. current account deficit (which includes goods and services) is not at a level that has historically caused the dollar to reverse course.

We doubt that the dollar will continue to advance as rapidly over the next year as the past year, but the fundamental factors that support the dollar are still in place. A steady move higher from current levels seems likely, in our view.

What it means for investors

During periods of strong dollar appreciation, investments in international bonds tend to underperform domestic bonds. With bond yields below U.S. yields in many other countries, adding currency risk doesn't make sense to us. Even where yields are higher than in the United States, such as in EM bonds, a rising dollar can more than offset the incremental yield offered.

We continue to suggest that investors underweight foreign bonds in their portfolios. We also suggest underweighting commodities due to the combination of excess supply, weakening demand and a rising dollar.

1. Schwab Center for Financial Research.

Source: www.schwab.com

Category: Bank

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