Hard Currency: The Strong US Dollar By: Gabriel PotterMBA, AIFA® 2015.05.12

Cause of weakness in corporate earnings

The United States corporate earnings numbers have suffered relative weakness in the 4th quarter of 2014 and the 1st quarter of 2015.  Some of the causes of weak earnings are one-time irregular actions, such as the increased corporate pension liabilities stemming from updated actuarial rules of 2014.  Beyond these one-shot issues, there are two ongoing factors which appear conducive to economic growth, but have led to recent problems:  the price of energy and the strong dollar.

We have directly considered the falling price of energy in our blog posts (“The Price Ceiling on Oil” - December 31, 2014) and in our monthly articles (“The Energy Sector” – December 2014).  On the other hand, we have only tangentially addressed the implications of a strong US dollar.  So, in this paper, we will review the strong US dollar and what it means for investors.

Pros and cons of a strong dollar

First, let’s define a strong dollar and then enumerate some of its advantages and disadvantages.  Simply put, a strong currency, or a “hard” currency, has a great deal of buying power.  A strong currency maintains its buying power over time, so it is strongly associated with an inflation-averse, “tight”, restrictive monetary policy from that government’s central bank.  A strong currency is stable and widely used between global trading partners.  Conversely, a weak currency, or a “soft” currency, is subject to price swings, instability, and is associated with potential loss in trading value versus other currencies or inflation.

A quick review of this definition makes it appear as if there are no disadvantages with a strong dollar.  There is, however, a key disadvantage to stronger currency:  exporting.  If your country derives most of its revenue from international trade, a strong currency gives you the opportunity to buy (or import) goods and services inexpensively.  However, a strong currency means that your exporters are at a disadvantage because the goods or services they are trying to sell on the open market are relatively expensive.

Correcting the dollar with trade

So, we’ve been talking about the dollar being strong, relative to other currencies, but what determines whether a currency is strong or weak?  Like everything else in economics, it is a case of supply and demand.  Global investors engage in currency trading for a variety of reasons, including hedging their current exposure, speculating on currency like any other investment, or conducting carry trades. For a greater understanding of this practice, we encourage you to read our March 25th blog post, “The Carry Trade”.

Global investors can buy, sell, and trade currencies, just like other goods.  Global investors determine a currency’s value by making and accepting trades on a free, open capital market.  The relative value of each currency is determined by daily market sentiment, optimism for a country’s growth prospects, analysis of monetary policy and macroeconomics, and a fair dash of random chance.  As the supply and demand for various currencies equalize on the open market, the global investment community determines which currencies get stronger and weaker.  Imagine, for a moment, you start off the year with a strong currency, wherein your importing power is high and your competitive exporting power is low.  This creates a trade deficit, where your country buys more goods and services than it sells to other nations.  Economic theory suggests, over time, this trade deficit should increase the supply of your currency (let’s say, dollars) being used across the globe.  Again, an increase in supply should thus reduce the currency’s relative value.  In other words, a trade deficit – in theory – should be a self-correcting phenomenon as a temporarily strong currency pushes so many dollars into the world

At least, that’s what is supposed to happen in economic theory.  Indeed, it’s what generally happens for “free-floating” currencies, assuming the relative value of your currency is determined by the free markets.  In other words, if investors around the world are freely allowed to buy and sell dollars (or Euros, Yen, Swiss Francs, etc.), your currency’s exchange rate is said to “float”.  The alternative is a government controlled, fixed exchange rate, where your nation’s central bank intervenes in the markets to maintain a specific exchange rate or an allowable one.  These currencies are said to be fixed, or “pegged” to another currency (usually the dollar).

Herein lays another issue.  You may have noticed some countries accused of currency manipulation.  China, for instance, has frequently been accused of pegging its currency at an artificially low exchange rate in an attempt to help their exporters stay competitive. 

Beyond setting a fixed peg in currency exchange rates, governments can use monetary policy or government intervention to manipulate their exchange rate.  For example, the Chinese government can buy trillions of US dollars – cash or treasury bills – and hoard these dollars as a foreign currency reserve.  This action has two effects.  First, it increases the scarcity of dollars, maintaining a hard currency in dollars and keeping Chinese currency relatively cheap.  Second, it means that China can – at any time – flood the market with excess dollars to destabilize the value of US currency and global trade.  This existential threat on the dollar has spooked investors and pundits for years.

The future of the dollar

The primary factors which are increasing the dollar’s relative value lately are more benign and less intentionally menacing:  central bank policy.  After the perceived success of US monetary policy (quantitative easing, low interest rates), other central banks are lining up to take the same approach.  Central banks in the European Union and Japan are conducting their own bond buyback programs, which could drastically increase the supply of Euros and Yen, at precisely the time when the US is considering tighter monetary policy, which should shrink the supply of dollars in circulation.  The practical upshot of this is, in the short term, the dollar may actually increase in strength relative to countries and regions, despite the fact that the dollar is pretty strong already. 

In the long term, there is really no way to tell what will happen to foreign exchange rates, since there are a number of competing factors at play.  So, let’s get to the point.  What does this mean for you, as an investor?   In practical terms, the irregularity and unpredictability of currency value means you could benefit from a diversified exposure to assets priced both in your home currency and other international currencies.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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