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Fixed-Income Insights

Here’s a look at the potential economic and market impact of the recent rise in the U.S. currency.

 

In Brief

  • The U.S. dollar has risen in value versus other global currencies in 2014, with a particularly strong advance in the past four months.
  • The rise could have significant implications for Federal Reserve policy and U.S. economic growth, especially if it helps keeps inflation in check.
  • Potential negatives from the dollar’s advance include a reduction in U.S. exports and reduced tourism from outside the United States
  • The key takeaway—Continued dollar strength likely would amplify the attractiveness of U.S. assets to foreign investors, while the adverse influence of weaker global currencies reduces the appeal of non-dollar-denominated investments to U.S. investors. A prolonged period of dollar strength could result in higher interest rates and/or even lower currency values in some countries.

 

The U.S. dollar has been on a tear in 2014—especially in the last few months. And the recent rapid rise in the greenback’s value versus other global currencies may have some far-reaching consequences.

For one thing, continued dollar strength could have a significant impact on the Federal Reserve. A strong dollar can reduce U.S. inflationary pressures—a phenomenon that would be welcomed by consumers—but it also may contribute to slower U.S. growth. That combination of slower inflation and slower growth could delay the Fed’s plan to raise the fed funds rate from the central bank’s implied timetable of mid-2015.

A delay or slower pace of interest-rate hikes could have significant investment implications. So, too, could the impact of a stronger dollar on earnings of multinational companies and the attractiveness of U.S. assets for foreign investors.  A burst of dollar strength can create volatility in financial markets, but a protracted rise could meaningfully change the investment landscape for years.

Just how far has the dollar advanced this year? Take a look at the performance of the Bloomberg Dollar Spot Index in Chart 1. This trade-weighted index of 10 leading global currencies shows the dollar has appreciated nearly 8% in the last four months.

 

Chart 1. The U.S. Dollar Has Sharply Risen in Value versus Other Global Currencies
Bloomberg U.S. Dollar Spot Index, 1/1/2014-11/4/2014

Source: Bloomberg. The Bloomberg Dollar Spot Index represents both developed and emerging market currencies that have the highest liquidity in the currency markets and the biggest trade flows with the United States.
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment.
Indexes are unmanaged and are not available for direct investment.

 

The Good Part
There could be some positive outcomes for the U.S. economy should the dollar continue to dominate. That would be good news for U.S. vacationers planning to travel abroad, and great news in general for U.S. consumers, who would pay less for imported goods. A stronger dollar increases consumer buying power as it restrains, if not lowers, inflation. 

That last point is especially important. In addition to its potential benefits for consumers, lower inflation can affect investments as well.  Lower inflation reduces the yield premium embedded in the interest rate investors expect on various fixed-income investments. Bond yields might be lower, and bond prices higher, than they would be in a higher inflationary environment. 

In combination with a stronger underlying currency, such stable or declining inflation increases the appeal of U.S. investments to foreigners, potentially adding to price support for these investments.  Increased foreign purchases can also further boost the value of the dollar, reinforcing the cycle. 

The Bad Part
But there are other consequences to a strong dollar.  If a strong dollar reduces the price of imports, sales of similar U.S.-produced products may suffer, potentially weakening domestic growth.  A stronger dollar also increases the price of exports, reducing U.S. global competitiveness.  Reduced exports eventually affect production and employment. 

If the improved buying power of a strong dollar promotes travel outside the United States rather than to domestic destinations, the economic stimulus of such spending would help foreign economies, not the United States.  Similarly, a stronger dollar makes the United States less affordable to prospective international leisure travelers, reducing visits, vacations, and the associated spending that would advance U.S. growth. 

So, while a robust dollar can produce enjoyable benefits related to low inflation, prolonged strength in the currency has the potential to adversely affect U.S. economic growth.  

The Fed Part
The double-barreled impact of dollar strength—downward pressure on inflation and reduced support for economic growth—seems aimed squarely at the Fed.  After more than five years of accommodative monetary policy directed at increasing inflation and promoting stronger economic growth, and with the prospect of three consecutive quarters of 3% or more GDP growth tantalizingly close, the Fed now faces a potential policy headwind in the form of dollar strength. 

For more than two years the Fed has not been able to raise inflation up to its target of 2%.  Additional downward pressure on inflation from a stronger dollar makes it even more difficult for policymakers to reach that objective. The Fed’s other objective, full employment, also faces a tougher environment if continued dollar strength hampers exports, vacation spending, and the jobs that accompany both.

Clearly, continued dollar strength has the potential to delay the Fed’s intended rate hikes, currently slated to begin midyear 2015.  If an ascendant dollar keeps inflation low and restrains growth, the Fed may be expected to extend its zero interest rate policy, and then proceed incrementally when eventually it does start to raise interest rates.

Investment Implications
Any delay and/or slowdown by the Fed in raising interest rates could extend investor interest in riskier assets.  Equities, high-yield securities, and dollar-denominated emerging market debt could each benefit from a less aggressive Fed approach to policy normalization. In fact, nearly all U.S. debt would benefit from an environment in which interest rates rose at a slower pace. A more direct impact of continued dollar strength would be the increased appeal of U.S. assets to foreign investors; a stronger dollar could enhance their returns via currency impact beyond any expected income or price appreciation.

At the same time, foreign currency weakness (the reciprocal of dollar strength) could impair returns on foreign assets, making them less attractive to U.S. investors.  Within the U.S. equity market, multinational companies are likely to see their earnings suffer from the conversion of earnings from weaker-currency countries to a stronger dollar.  Exporters, too, are likely to see profits impaired as their goods become more expensive after conversion to local currency.  On the other hand, healthcare and utility companies remain generally U.S.-centric and may be little affected by currency movements.  Similarly, many mid- and smaller-sized U.S. companies have only domestic operations and few exports, a combination that would likely shield their earnings from negative currency effects. This contrasts with larger companies in the S&P 500® Index, where about 46% of revenues come from outside the United States, according to S&P Dow Jones Indices. The recent dollar strength has been compressed in a relatively short time, but already investors are becoming more wary of companies with non-dollar earnings exposure.

Geopolitical instability and the relative economic strength of the United States—two factors that likely have provided dollar support—seem poised to continue for some time.  Also supporting continued dollar strength is the prospect of tighter U.S. monetary policy and the attractiveness of resulting higher U.S. short-term interest rates in contrast with further economic uncertainty and lower rates in the eurozone and Japan.  Continued dollar strength would only amplify the attractiveness of U.S. assets to foreign investors, while the adverse influence of weaker currencies reduces the appeal of non-dollar-denominated investments to U.S. investors.

What about the longer term? If global investment flows from other countries to the United States become prolonged, the result may be higher interest rates and/or even lower currency values in some countries.  Such a combination would eventually transfer investment demand (reflecting the impact of higher interest rates) and demand for cheaper goods and services (a likely outcome of currency weakness) from the United States to elsewhere in the world, promoting a rebalancing of global growth.  Until that time, astute investors will be wise to consider the factors influencing dollar strength—and the impact of a strong U.S. currency on both Fed policy and the various investments in their portfolios.


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