US Dollar Strength and US Stocks
David R. Kotok
Cumberland, January 19, 2015
“What does U.S. dollar strength mean for U.S. stocks? When companies become large and global, with sales sourced from a broad swath of countries and currencies, they develop natural portfolio hedges (as opposed to synthetic hedges using derivatives). Theoretically, gains in one currency (e.g., the U.S. dollar) would be offset by losses in another currency (e.g., the yen), resulting in a reduced sensitivity to currency swings. In other words, we don’t want to overstate the importance of the U.S. dollar vis-à-vis the S&P 500. The S&P 500 rose during the strong dollar regimes of the late-70s to the mid-80s, and the mid-90s to the early-00s. We appear to be in the third strong dollar regime since 1973.”
Talley Léger, January 17, 2015, MVR Weekly Research
Readers who wish to see the entire piece may request it from Talley Léger via the “Contact Us” link on his website. Please note that Talley is co-author with me of our new book, the second edition of From Bear to Bull with ETFs. It is now available in e-book and paperback at Amazon.
Let’s embellish on Talley’s point.
We know about currency volatility and fluctuations in the foreign exchange markets. The most recent and dramatic lesson has come with the Swiss National Bank’s abrupt policy change that removed the peg of the Swiss franc to the euro. Several days of market turmoil followed. Revelations continue as this is written. There are reports of some fully collapsed entities that had invested with a wrong-way bet on the Swiss franc. For details concerning one, see Bloomberg.
Markets are still trying to figure out the damage wrought by the Swiss action. Reports of debt risk in Poland and Hungary have surfaced. There are reports of troubles in the eurozone with an Austrian bank. For details see WSJ. We expect more revelations as the days pass.
But what about the dollar?
There is little evidence that the Swiss action will interfere with the strengthening trend of the US dollar. In fact, many expect both the dollar (USD) and the Swiss franc (CHF) to show stronger results against many other currencies, including the euro and the yen. We agree with that general assessment but want to distinguish between the Swiss and the US central banks. The difference between CHF and USD is that the Swiss will actively impose a negative interest rate on deposits denominated in Swiss francs in order to discourage inflows from non-Swiss sources. Switzerland has used this tactic in the past.
In the US, the Federal Reserve will not impose a negative interest rate and is expected to commence a gradual extraction from quantitative easing (QE) by the end of this year. So The Fed will be raising rates, while the Swiss will be lowering them. And the US dollar is the world’s reserve currency so the US is not worried about inflows. US central bank policy is focused on the US economy. Switzerland’s issues are of secondary importance for Federal Reserve officials.
At Cumberland, we expect the Fed’s policy rate to reach about 0.50% by the end of 2015. Others have differing estimates of the path of restoration of normalcy by the Fed. And we believe that the Fed itself has not fully decided. So if the Fed doesn’t know, how can anyone outside the Fed know?
There is market-based pricing that estimates the path of Fed restoration. On January 15, Barclays calculated this path to lead to a 2.5% fed funds rate in 2022. Barclay’s work suggests that “the market is pricing in the fed funds rate to remain below 2% until 2019.” LIBOR futures-based estimation gives a similar path. The bottom line for the Fed’s policy is an expectation of very low rates for several more years.
So what will happen to the USD?
BCA Research observes that “the U.S. dollar moves in big cycles.” They estimate that USD “trade-weighted” strengthening is up 23% so far in this cycle. BCA notes that the cycle in the 1990s involved a total move of 53%. The move of the late 1970s to mid-1980s was 57% according to their estimates. They add JPMorgan Chase as a research source in their calculation.
If BCA is correct, we may not be even halfway through the strengthening move. And Switzerland’s action is not a significant weight in the traded-weighted calculation.
The bottom line is that this seems to be a cycle of dollar strengthening that will be measured in years. And if Talley is correct, the influence of the strengthening dollar, while important for sector selection, is not enough to derail a bull market by itself.
At Cumberland, we have been emphasizing the domestic sectors in our US ETF strategies. Utilities are 95% sourced in the US. They are overweighted in our domestic US ETF portfolios.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors