- The US dollar's recent upside breakout has brought questions about the reasons, as well as implications for the stock market.
- A strong dollar has historically been stock market-bullish; however relative dollar stability is preferred over spikes.
- There is little reason to fret the dollar losing its reserve currency status.
Given the recent upside breakout in the dollar I've been getting a lot of questions about the reasons behind the strength as well as implications for the stock market.
Reasons for the dollar's strength:
- Strengthening US 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 US 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 US 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
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
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.
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
|US dollar index momentum||S&P 500 annualized gain|
|-2% and 2%||10.6%|
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.
We have been dollar bulls and ultimately believe it's reflective of, and beneficial to, the US 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. I've written and commented a lot about the comparisons between today's stock market fundamentals and backdrop and that which existed in the mid-to-late 1990s. One of those similarities relates to the positive correlation between stocks and the dollar.
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." As highlighted in a July post on EconoMonitor, the dollar, at this stage, has no viable contenders (those who assumed the euro was at the top of the list have likely reconsidered). 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).
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.
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