Movement of the U.S dollar is one of the primary drivers that determine the relative performance of U.S. and international investments. Over the five-year period ending February 28, 2017, the difference between international returns expressed in dollars vs. local currency was about 4.5% annually. This means the effective yearly return for a European investor was 4.5% higher if he did not convert his or her holdings back into dollars. Many factors influence currencies, some primary, others secondary. The resulting interactions remind us of a river. The primary direction of currency movements is the main flow of the river, determined by large forces such as major macroeconomic and monetary policies. Yet there are times when the currency markets run against what should be their longer-term direction. They are like eddies in the river, places where the water runs, at least temporarily, against the river’s ultimate direction.
A primary direction of the currency “river” is determined by relative interest rates. All else being equal, countries with higher interest rates have their currencies appreciate relative to countries with lower interest rates. While this may seem obvious, it goes against what had been an accepted economic theory called “interest rate parity,” which assumed that higher yielding currencies would ultimately experience depreciation. In a world of efficient markets, why should investments in a certain currency be rewarded by both higher interest rates and appreciation? Shouldn’t the excess return come with additional risk?
Which way is the river flowing now? U.S. interest rates are higher at almost all maturities than comparable rates for other currencies considered safe with liquid bond markets. Since the first interest rate hike over 15 months ago, no major developed market country has raised rates, and none are expected in 2017. One would think the currency river should be flowing to the U.S. The dollar, however, is not responding as expected. After an initial rally following the U.S. presidential election, the dollar has stalled. The March 2017 Fed interest rate increase, which seemed unlikely at the beginning of the year, has failed to fuel the dollar rally. We may be witnessing an eddy in what should be a strong U.S. dollar current. Why?
Candidate Trump promised to name China a “currency manipulator” on his first day in office. It is not unusual for campaign promises to be delayed or ignored. Treasury Secretary Mnuchin has stated that no decision will be made until April at the earliest. President Trump has other advisors that have been very hawkish on China, and this view may carry the day. If the Trump administration adopts a skeptical view on either China or trade, it could create weakness for the dollar.
The border adjustment tax (BAT) is a piece of the broader corporate tax reform plan being considered by the House. The BAT would place an additional tax burden on companies that import goods to the U.S. (by disallowing certain tax deductions) but grant favorable tax treatment to companies that export goods from the U.S. (by fully allowing tax deductions). Such a system would be controversial under global trade law, which does not allow extra tariffs on goods beyond those broadly agreed to through the World Trade Organization (WTO). Many countries, however, have a value added tax (VAT) that operates in a similar fashion.
The consensus among economists and the proposal’s sponsors is that the VAT would strengthen the dollar. The presumed strengthening of the dollar is cited by the sponsors as offsetting the cost of the tax that would be passed on to consumers. The BAT was facing an uncertain future even before the failure to bring the healthcare bill to a vote on the floor of the House. Concerns about the BAT may be creating an eddy for the dollar.
The value of the dollar is important for investors who have diversified a portion of their portfolios with overseas investments. We think that the fundamental strength of those investments could overcome a modestly stronger dollar that may come from the interest rate differential between the U.S. and other countries. Other factors seem to have hampered the dollar’s rise, benefiting international investments. We may be seeing just a temporary eddy in an underlying current that favors the dollar.
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- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
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- Data provided by LPL Financial.
- Because of its narrow focus, sector investing will be subject to greater volatility than investing more broadly cross many sectors and companies.
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- International investing involves special additional risks. These risks include, but are not limited to, currency risk, geopolitical and regulatory risk