When the Dollar Cracks

Weakening U.S. Dollar Might Signal Shifting Winds

The U.S. dollar has been quite strong since the high in U.S. stocks set in January of 2018.  As the markets are approaching new highs, they still are not much higher than they were nearly two years ago when the dollar began its run.  Using the Invesco DB US Dollar Index Bullish Fund as a proxy, the dollar has appreciated 15% since January 2018 and nearly 25% since its June 2014 lows.

Why the Dollar Strength?

There are many factors, of course, that influence the strength and weakness of the dollar at different times.  I’ll posit a few that likely have recently influenced the greenback:

• Relatively Higher Interest Rates in the U.S.  While our rates have recently hovered near all-time lows (with the 30-year Treasury bond yield actually having set new record lows under 2%), they still are quite a bit higher than most of the rest of the world.  As I write this, amazingly, even the beleaguered Greek bonds have lower yields than we do despite having hovered near default a few years back.  The higher rates have served as a magnet for investments thus incurring a strong bid for dollar-denominated assets such as U.S. treasuries.
• Repatriation Impact of 2017 Tax Cut and Jobs Act.  The tax law that went into effect in 2018 essentially unlocked billions of dollars that had been kept overseas to avoid taxes.  The new law was much friendlier thus many companies brought funds back to the U.S., oftentimes exchanging foreign currency for the dollar.  This provided another bid for the dollar.
• Trade War with China.  The U.S. seems to have the upper hand since we import much more from China than we export and thus the impact of tariffs can potentially be greater.  However, China can more subtly adapt by letting the value of their currency slide.  (As an aside, this can be a dangerous game for China as they want to make sure that they avoid a big outflow of money from their currency with money leaving the country.)  So, a 15% tariff can be essentially nullified with a 15% currency decline.  China has used this tool which has also put upward pressure on the dollar.

Is the Dollar Starting to Reverse Course?

As we approach the end of 2019 many of these underpinnings for the dollar may be fading or reversing.  The Fed has shifted from tightening to easing and at some level even restarting quantitative easing by another name.  The repatriation has probably been completed. Finally, the trade war may be calming down with announcement of the first step to a comprehensive agreement.

Impeachment.  I generally recommend that investors ignore politics unless it has a clear and definite impact on economic fundamentals.  And, even if it does, the “devil is in the timing”.  Having said that, I do believe that markets are not crazy about leadership vacuums.  In particular, the symbolism of the dollar representing our strong nation can be impacted when a vacuum develops.   Over the past week or so, the dollar strength has shown some signs of cracking.  However, it would be premature to say there is a vacuum or the dollar has peaked.  Nonetheless, it may be an early warning sign.

Looking back at the Nixon resignation and the Clinton impeachment, it is clear to me that in the first case there was a definite leadership hole and a brutal bear market while in the latter case, Clinton never seemed to lose his political popularity so the market just sailed right along in an epic bull market!

When Headwinds Become Tailwinds

We have always believed in the benefits of diversifying long-term portfolios by adding investments in non-U.S. stocks to their U.S. equities.  However, when the dollar is strong, the investments denominated in other currencies hit a headwind as the holdings have to overcome the built-in depreciation of their currencies weakening.  Of course, when the dollar weakens, the headwind becomes a tailwind with built-in appreciation.

We don’t try to time the dollar moves but believe that over time, while the dollar moves up and down, eventually what matters is owning good companies that generate solid earnings over the years.  Nonetheless, if the dollar does head lower, we might expect many international investments to begin to catch up to their U.S. brethren.

Stay diversified!