In the first half of the year, the US dollar (as measured by the US Dollar Index – DXY:CUR Bloomberg) and the S&P 500 were both coincidently strong. The dollar rose 6%, reaching its closing high so far this year at 84.58 on July 9. In the same time period, the S&P 500 went up 15.9%. There are many good reasons for the dollar to be strong.
As the world's reserve currency, it is the dominant medium of exchange for global transactions. Consequently, it is in high demand from foreigners. In order to facilitate world trade and maintain a stable ratio of reserves, the US has to increase the supply of dollars, as well as US debt, in line with global growth. Historically, that supply of dollars was generated from an increasing current account deficit. Debt was issued by both the private and public sector. More recently, liquidity has been provided by a number of monetary and fiscal stimulus programs.
There is an inherent balancing act in this relationship, though. In this month's Jackson Hole conference, we can see the beginnings of a conflict between domestic and international interests. The Federal Reserve is contemplating reducing its purchases of US debt at the same time that the deficit is coming down. Emerging economies are particularly concerned about the implications of reduced dollar availability will have on their own economies.
Compounding this issue is the reduction of the current account deficit. US consumers no longer have the capacity to borrow and consume at the levels prior to 2008. Although consumption (as measured by the Personal Consumption Expenditure index) has gone up somewhat, the current account deficit continues to go down. The major factor in its decline is the increasing domestic production of oil (and improved vehicle energy efficiency) has meant a reduction of $400 billion in annual imports of oil than at the peak in 2008.
The slow end of quantitative easing and the falling demand for energy imports should favor the dollar. Yet, on August 11, there was an article in the Wall Street Journal titled "Doubts Arise Over U.S. Dollar's Strength." The article cites disappointing economic data such as weaker than expected jobs growth and retail sales that may influence the Federal Reserve's schedule of tapering bond purchases. Since many believe that the market has priced in significant reduction in bond purchases over the coming year, any delay may reduce the attractiveness of the dollar, at least, short term. There are also encouraging economic statistics coming out of Europe, which has bolstered the euro. The yen, too, has shown signs of strength. And China's slow down appears to have stabilized.
Nicole Hong, the author of the Wall Street Journal piece, speculates that a weaker dollarwould bolster corporate earnings as multinational companies find that profits made outside the U.S. are worth more when translated into dollars. Emerging markets, which have suffered recently, may become attractive again.
Stephen Jen, a founding partner of London hedge fund SLJ Macro Partners, says in the article, "We need to see better data in the U.S., and we need to see weak data in the rest of the world. If this thesis is undermined, then the dollar will struggle."
We feel that strong fundamentals are in place which should benefit the dollar on a relative basis over the long-term. However, there are many factors, domestic and international, that may lead to increased short-term volatility.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. They are those of the authors. Investing involves risk, including loss of principal. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. International and emerging market investing involves special risks such as currency fluctuations and political instability and may not be suitable for all investors. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, and bonds are subject to availability and change in price. The economic forecast set forth in the presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.