Monday , 2 December 2024

Why the USD Is So Strong & the Implications For the Economy & Stock Market (+2K Views)

Given the recent upside breakout in the dollar I’ve been getting a lot of questionsdollar about the reasons behind the strength as well as implications for the stock market. [Here are my views on the situation.]

The above introductory comments are edited excerpts from an article* by Liz Ann Sonders (schwab.com) entitled Liz Ann Sonders: Million Dollar Question – Is the Dollar’s Strength Bullish?

Sonders goes on to say in further edited excerpts:

Reasons for the U.S. dollar’s strength:

  • Strengthening U.S. economy (both in absolute and relative terms)
  • Federal Reserve moving toward monetary policy normalization vs other global central banks—notably the European Central Bank (ECB) and the Bank of Japan (BoJ)—which are still aggressively easing policy
  • Stronger U.S. growth and higher interest rates makes the United States a more attractive locale for investments; prompting the buying of dollars
  • US energy renaissance means improving U.S. trade/current account deficits; possibly leading to a shortage of dollars abroad
  • Global yield gap: US 10-year Treasury yield trading more than 50 basis points above the G6 composite (historically dollar-bullish)

Economic benefits of a stronger dollar:

  • Lower import prices (e.g., oil and autos) leaves more discretionary spending power
  • Lower commodity prices for those priced in dollars (as the dollar appreciates, commodities become more expensive for overseas buyers, who have to convert their weaker currencies into dollars; curbing global demand)
  • Makes foreign travel cheaper for Americans

Negatives of a stronger dollar:

  • Makes exported products more expensive and less competitive in foreign markets
  • Money earned in foreign currencies is worth less when converted back into dollars

As you can see in the longer-term chart of the dollar below, for much of the period between the mid-1980s and late-1990s the trade-weighted dollar index was largely range-bound.

27-Year Dollar Chart

27-Year Dollar Chart

Source: FactSet, as of September 12, 2014.

In the period between the Internet bubble burst-led recession in 2001 and the global financial crisis in 2008, the dollar was in a deep and steady downtrend. Since then, it’s moved back into a range-bound pattern; but the latest move up is notable. It may be too soon to declare the beginning of major/secular move higher, but as you can see in the shorter time frame below, the breakout from a technical perspective is notable.

2-Year Dollar Chart

2-Year Dollar Chart

Source: FactSet, as of September 12, 2014.

In general, a stronger dollar is likely to be both an economic and market positive. As you can see in the table below, since the late-1970s, the stock market has performed twice as well during dollar bull markets than during dollar bear markets.

S&P 500 performance during dollar bull & bear markets

Source: FactSet. *As of September 12, 2014.

However, as is the case across asset classes, sometimes a sharp movement—even if directionally positive—can cause some short-term volatility. As you can see in the graphic below, what the market likes best is stability in the dollar.

Dollar Breaks Out of Best Momentum Zone

Dollar Breaks Out of Best Momentum Zone

9/4/1987-9/12/2014
US dollar index momentum S&P 500 annualized gain
> 2% 4.5%
-2% and 2% 10.6%
< -2% 1.8%
Source: FactSet, The Leuthold Group, as of September 12, 2014. US Dollar Index Momentum = 3-week moving average of 6-week rate of change.

Double-digit market returns have been the norm during period of limited dollar movements. Returns are diminished when the dollar’s momentum moves out of that band; however they remain in positive territory, and are better when the dollar is rising than when it’s falling.

Revenue exposure matters

From Bespoke Investment Group’s (BIG’s) International Revenues database, they looked at the performance of Russell 1000 stocks that generate more than 50% of their revenues outside of the United States (“international basket”) and compared it to those that generate less than 50% (“domestic basket”). Since the dollar made its lows on May 6, the international basket is up 3.7% (through Friday, September 12), while the domestic basket is over 6%. This is in contrast to the period from early July 2013 until the low in May this year; during which time the international basket outperformed the domestic basket.

King dollar

We have been dollar bulls and ultimately believe it’s reflective of, and beneficial to, the U.S. economy and its relative strength globally. We also believe the correlation between the dollar and the stock market will remain positive. However, in the short-term, there is some risk that third quarter corporate earnings could be dented by the dollar’s recent surge—at least at multi-nationals…

Reserve status

Let me wind down on a broader topic around the dollar about which I get many questions from investors. “Will the dollar lose its reserve currency status any time soon?” My short answer has been consistently “no.”

[Why? Because]...

  1. the dollar, at this stage, has no viable contenders (those who assumed the euro was at the top of the list have likely reconsidered).
  2. In addition, the United States is a trade deficit nation; and has been for decades. As such, there are huge stockpiles of US dollars in foreign hands which is a necessary condition for reserve status. Good luck finding another country that would be willing to run large trade deficits in order to get reserve currency status (it’s unlikely China would).
  3. The United States also has the largest and most liquid Treasury market in the world, while the Fed has clearly demonstrated its willingness and ability to be the lender of last resort. According to the Financial Times, over half of all global cross-border deposits and lending are transacted in US dollars. In the last global survey of the $5 trillion/day foreign exchange market, the US dollar was on one side of 87% of all trades. This is why many global central banks say they still see no true alternative to the liquidity and relative safety of the US Treasury market; and hold more than 60% of their reserves in US dollars.
Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.

*https://www.schwab.com/public/schwab/nn/articles/Million-Dollar-Question-Is-the-Dollar-s-Strength-Bullish (© 2014 Charles Schwab & Co., Inc, All rights reserved. )

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