by Kathy Jones, Head of Fixed Income, Charles Schwab & Company
A trifecta of factors support the dollar, including the relatively strong performance of the U.S. economy, tightening monetary policy by the Federal Reserve, and safe-haven buying. These are likely to remain intact into 2023.
The dollar has posted a sharp rise since mid-2021
Bloomberg Dollar Spot Index (BBDXY Index). Daily data as of 8/3/2022, 3:25pm ET. Past performance is no guarantee of future results.
Meanwhile, many emerging-market currencies have plummeted versus the dollar—some to all-time lows.
Emerging-market currencies have plummeted vs. the dollar
World Currency Ranker (WCRS). Data from 8/2/2021 to 8/2/2022. Past performance is no guarantee of future results.
Factors supporting dollar strength remain intact
U.S. GDP growth has outpaced GDP growth in Europe and Japan
GDP US Nominal Dollars SAAR (GDP CUR$ Index) as of Q22022, Eurozone Nominal GDP (Billion USD) SAAR (ECOXEAS Index) as of Q12022, and Japan GDP at Current Prices Seasonally Adjusted: GDP Quarterly (JGDOSGDP Index) as of Q12022. Percent change in nominal GDP normalized from 9/30/2019.
Interest rate differentials reflect this relative economic strength, adding to the dollar's appeal. Due to the Federal Reserve's aggressive pace of rate hikes, yields on U.S. Treasuries are significantly higher than in most G-7 countries, aside from a few commodity-producing countries. If the Fed follows through on further rate hikes this year as expected, short-term interest rate differentials will likely widen further as U.S. yields rise more rapidly than yields in other countries.
Currency hedging costs may reduce the attractiveness of U.S. bonds for some foreign investors, but net foreign investment flows into the U.S. continue to be positive and domestic investors have little reason to shift money abroad.
Global 2-year yields partly reflect relative economic strength
U.S. (USGG10YR Index), Germany (GTDEM2Y Index), Italy (GTIT2Y Index), Greece (GTGRD2Y Index), U.K. (GTGBP2Y Index), Canada (GTCAD2Y Index). Daily data as of 8/3/2022, 3:33pm ET. Past performance is no guarantee of future results.
In addition, investors who borrowed in U.S. dollars to invest in higher-yielding EM currencies—a strategy known as the "carry trade"—have seen steep losses. A negative cycle has unfolded where capital outflows send EM currencies lower, leading their central banks to raise interest rates to stem the outflows, resulting in weaker growth.
Not surprisingly, EM bonds—both U.S dollar (USD)-denominated and those issued in local currency—have produced sharply negative returns in the fixed income market over the past year.
EM bond returns have been negative
Bloomberg Emerging Market USD Aggregate Bond Index (EMUSTRUU Index). Total returns based on daily data between 12/31/2020 to 8/2/2022. Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
Foreign holdings of U.S. Treasuries remain high
U.S. Treasury Major Foreign Holders Total (HOLDTOT Index). Monthly data as of May 2022.
No alternative to dollar dominance
There simply aren't many alternatives to the dollar that will fill these needs. The euro plays a large role in financial transactions, but its fragmented bond markets and long period of negative interest rates have limited its usage. Japan's zero-interest-rate and yield-curve-control policies make it unappealing. There is always speculation about China's yuan becoming more prominent as a global currency, but it's not even freely convertible due to capital controls.
Implications of a strong dollar
For investors, the combination of a rising dollar and high U.S. interest rates make maintaining a globally diversified bond portfolio challenging. The yield to worst on the Bloomberg Global Aggregate ex US Index is only 1.84% with a with a duration of 7.6, compared to a yield of 3.42% for the U.S. Aggregate Bond Index (Agg) with a duration of 6.3. When factoring in the 14% increase in the dollar and the yield differential, the broad international index has dropped 18% over the past year, about twice that of the U.S. index.
Global Agg yield to worst is lower than for the U.S. Agg
Bloomberg U.S. Aggregate Bond Total Return Index and Bloomberg Global Aggregate (x-USD) Total Return Bond Index (LBUSTRUU Index, LG38TRUU Index). Daily data as of 8/3/2022, 3:40pm ET. Yield to worst is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting. Past performance does not guarantee future results.
Overall, the factors driving dollar strength look likely to persist into next year. We suggest investors keep allocations to non-U.S. fixed income securities to a minimum.