Making Head or Tails of the Currency Market
We have not discussed the currency market for a while. However tracking movements in currencies is crucial in trying to decipher what is happening in other financial markets. And regardless whether or not you trade or hold foreign currencies in your portfolio, the relative strength of the dollar affects your investments. Consider the following. The competitiveness of multinational firms is closely linked to the price of their goods in foreign markets. A weaker dollar versus the riyal, for example, makes Boeing’s aircrafts cheaper for Qatar Airlines to purchase relative to planes produced by Airbus. Boeing’s share price would tend to appreciate, ceteris paribus, when the dollar falls. Likewise, a weaker dollar makes all of Apple’s foreign currency holdings abroad worth more in dollar terms, and therefore more attractive to repatriate to California (especially now under Trump’s new fiscal plan). Apple’s shares will appreciate with a weaker dollar. Next, think of all commodities whose prices are quoted in dollars: crude oil, copper, aluminum, wheat, gold, etc. For the real price of a commodity to remain stable in a falling dollar environment, the nominal price of the commodity must appreciate. Conversely, a stronger dollar tends to put downward pressure on oil prices, and oil company stocks underperform. In addition, exchange rates may cause inflationary or deflationary pressures in an economy. Import prices may contribute to inflation if the national currency depreciates relative to currencies of trading partners. Prices of imported goods (in the home currency) rise in consequence. At a time when the Federal Reserve is watching closely inflationary pressures with the Personal Consumption Expenditure index now at the central bank’s target level, a bout of dollar weakness could put upward pressure on the import price index and force the Fed’s hand to tighten rates at a quicker pace. Finally, more directly for investors, even if your portfolio only holds U.S. dollars, your holdings of foreign company shares will react linearly to movements in the value of the company’s home currency versus the dollar. In sum, an investor needs to be conscious of the relative strength and trend of his/her home currency.
We will focus on the U.S. dollar in this report, as the dollar is the world’s reserve currency in which most commodities are priced and most of our investors have the USD as their base currency.
To get a big picture view of the dollar historical performance, let’s begin with a 30-year chart of the “Dixie” (“DXY”, ticker for the U.S. dollar index), which measures the dollar against a basket of currencies containing euros, pound sterling, Canadian dollar, yen, franc, and krona. The first chart is just to remind readers that the natural direction for the world’s reserve currency is down. Since the forced depreciation of the dollar during the Plaza Accords in 1985, the dollar has been in a 30-year downtrend. Recall that prior to the dollar, the world reserve currency was the British pound, which suffered the same fate. The reason why the world’s reserve currency has always depreciated over the long-term is that the country holding the reserve currency must keep the world awash in dollars (previously pounds), meaning that the country runs persistent balance of payments deficits (Triffin dilemma). Persistent BOP deficits create a downward spiral for the reserve currency.
Note in the chart above, since 1985, the dollar has performed best in periods of crisis or recession (1987, 1990-91; 2000-2003 ; 2008-2009) with the exception of 2014-2016, which is likely due to the persistent intervention of our friends, the sorcerers’ apprentices.
Closing the Dixie chart to a four-year daily below, we see that the false break-out after the U.S. election in 2016, the 2017 downtrend (supporting U.S. equity out-performance), and finally the break below the 2015-2017 plateau (red horizontal line) around $93. The Dixie’s fall was stopped when world equities turned down last January. After three months of basing around the $90 handle, the Dixie is mounting a rally.
Lower highs & lower slows since the 2016 peak. The Dixie is still in a downtrend. Is the current bounce a major reversal? Not in our opinion. The relative interest rate spread between the U.S. (Fed Funds) and Japan (BoJ discount rate) and Europe (ECB discount rate) is nearing a maximum as shown in the next chart. The U.S. administration and Trump want a weak dollar. Wall Street wants a weak dollar. In the current environment, $95 is the ceiling on the current Dixie rebound. What would it take to get the Dixie above $95? A crisis or market panic. Bottom line, in the unlikely event that the Dixie breaks above $95, sell risk assets.
Refer back to the chart just above. Relative interest rates drive currency flows. If rates are anticipated to be higher in the U.S. than in Europe, then world investments will flow to dollar assets in seek of higher yields. According to Interest Rate Parity (IRP), if bonds offer a higher yield in the U.S. than in Europe, currencies will move such that a Japanese investor, for example, will not make a higher return, in yen terms, by investing in U.S. T-bills rather than German 3-month paper. Perhaps IRP answers the question why the dollar has depreciated even as the Fed has been raising rates faster than other world central banks.
The EUR/USD chart below shows just about the same thing as the Dixie (euro is 50% of the dollar index basket). We see the euro forming a major 2-year base in 205-2016 then breaking higher in mid-2017. With the new high made in 2018, even if the euro rally pauses here, we see more chance of reaching $1.40 than returning to $1.05.
Below is the yen-dollar chart (a rising price is yen weakness). The yen is a risk-off currency – in crisis periods the yen appreciates. Isn’t it curious that the yen/dollar is forming a similar wedge to that seen in the S&P 500 and Dow? If this curve breaks lower (below ¥104 and especially ¥100), there will be a good chance that equity markets will be in severe turbulence.
We will post charts of EM currencies that we’re following in Daily Updates in the coming weeks. Interestingly, most EM currencies are still in bear markets versus the dollar. At the same time EM stock markets have underperformed the NYSE. It’s no secret that equity investors have been better off in U.S. stocks over the past several years. However, EM stocks with local currencies beaten down (from the perspective of a dollar investor), are looking mighty attractive both on a relative basis and for a long-term holding. Currencies such as the India rupee (INR/USD) and Turkish lira (TRY/USD) look to be trading at crisis lows. Brave investors can begin to put a toe in the water here.
The dollar is rebounding after a 2017 down-cycle. The rebound won’t last, unless the world equity bull market and risk-on trade is ending. Dollar-based investors should use dollar strength in the coming days and weeks to rotate into attractive foreign stocks with cheap underlying currencies.
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