A dollar ain’t worth a loonie anymore
Throughout 2017 and into 2018 the U.S. dollar fell with relatively little interruption versus both a currency basket weighted by volume of trade (dominated by the Canadian Dollar and the Mexican Peso) and an index of other major currencies that see heavy transaction activity (including the Euro, Japanese Yen, British Pound, and Swiss Franc).
Source: Bloomberg 5/16/18. The USDX and the trade weighted dollar are indexed at 100 on 12/30/16. An investment cannot be made in an index. Past performance is no guarantee of future results.
That trend has reversed in recent weeks with potentially significant consequences. We address here the factors we believe to be driving that inflection in foreign exchange rates, where we think the dollar may be headed, and why that’s important.
Monetary policy divergence is frequently cited as a principal influence on exchange rates. The Fed is engaged in quantitative tightening, lifting bond yields and mopping up excess dollar liquidity around the world. In theory, that should absolutely be supportive of a stronger dollar, but it’s certainly not a new story and we are skeptical that this alone accounts for much of the sudden rebound. Another of the usual suspects is disparity in rates of growth, and here too we are among the doubters. Economic performance was a bit disappointing outside the U.S. in Q1, but the dollar bounce has come during the spring months as the outlook globally has brightened.
The proximate cause to which we attach the most credibility at present is trade policy. It was through the late winter and into the early spring that the Trump administration’s posture on trade became rapidly more aggressive. Fear of global trade being strangled has contributed to a rise in risk aversion and retreat to the dollar.
…succumb to gravity
Currency markets are notoriously difficult to predict, and we are loath to do so ourselves. The dollar could be up a year from now or it could be down – neither outcome would surprise us in the least. If we had to make a bet (and we don’t as you’ll read below) we would fall on the side of a declining dollar. Risk aversion and monetary policy is supportive in the near term, but foreign exchange rates will ultimately bow to the pressure of structural imbalances. The U.S. needs to sell a lot of dollar assets to finance an enormous federal budget deficit and a growing deficit in non-petroleum trade (the twin deficits). That relentless supply will eventually get the better of dollar bulls, or so we suspect.
Paid in dollars, shop in dollars – why worry about anything else?
The path the dollar follows is of great concern to investors. A strong dollar devalues earnings generated and assets held overseas. It also makes it more expensive for foreign entities to service dollar denominated debt, increasing default risks and slowing global growth.
Of course, there are risks to a rapidly declining dollar also. A weak dollar is inflationary in that the cost of imported goods rises. A stable currency is the best outcome.
Slicing it down the middle
Historically, investors generally choose between hedging their currency exposure or leaving it unhedged. We suggest a third option. Because it is so difficult to anticipate the zigs and zags of exchange rates, an entirely logical course of action is to adopt a neutral posture by hedging half of your exposure. It should make for a smoother ride.
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
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Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
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