If there’s one item that should be on every investor’s watch list, it’s the US dollar. The greenback has always played a dominant role in global trade and capital flows, but the tenuous state of the global economy has markets placing an even greater emphasis on the dollar’s value.
It is often said that currency depreciation is the last means by which governments can drive growth. Gross Domestic Product can be calculated as the sum of household consumption (C), business investment (I), government spending (G) and net exports (exports - imports).
The first three items are domestic in nature, while the last is the result of global trade. When household consumption and business investment are lackluster, as they are in many parts of the world, and government spending is constrained by excess debt (also the case in many areas), the remaining lever often comes down to net exports, which is heavily influenced by exchange rates.
A stronger domestic currency makes exports more expensive, suppressing sales, and also reduces the profitability of those sales once the proceeds are translated back into dollars. At the same time it reduces the cost of imports, which hurts domestic manufacturing as demand for domestically produced goods falls.
With most commodities priced in dollars, the strength of the dollar also has an outsized impact on commodity prices, which represent the base input for most products and thus play a role in overall inflation.
Monetary policy is also dependent upon the dollar’s value. One could argue that the dollar was completely responsible for the Fed’s decision last week to hold off on raising interest rates. Consider some of the following statements from Yellen’s press conference:
… net exports were a substantial drag on GDP growth during the first half of the year, reflecting the earlier appreciation of the dollar and weaker foreign demand …
Developments since our July meeting, including … the further appreciation of the dollar … have tightened overall financial conditions to some extent. These developments may restrain US economic activity …
… appreciation of the dollar and declines to energy prices are holding down inflation well below our target and well below core inflation.
… a somewhat stronger dollar and higher risk spreads thus represent some tightening of financial conditions.
And perhaps more telling was Chair Yellen’s response to a question by Michelle Fleury of BBC News. Fleury asked whether the FOMC’s policy decisions affect the dollar and if the dollar is a consideration when making policy decisions. Yellen responded:
It’s one of a number of different channels by which monetary policy works but it does have some impact on exchange rates and of course, yes, we need to take that into account. With so much riding on the value of the dollar, including monetary policy decisions, the dollar should have your undivided attention. If you aren’t watching, you won’t be able to anticipate how conditions will change.
As a quick review, here’s a chart of the US Dollar Index which shows the value of the dollar against a basket of currencies. While looking at individual exchange rates would provide a more granular view, this is a good starting point and may be sufficient for some investors.
We could make things very complicated, but applying the KISS principle would leave us with this: from a US perspective, a stronger dollar is bad, a weaker dollar is good.
A weaker dollar will improve the outlook for economic growth, corporate profits and inflation. In terms of equity markets, a weaker dollar will act as a tailwind to higher stock prices, particularly for multinationals. It would also be a welcome shift for emerging markets, which have been hit by fund outflows stemming from the dollar’s strength.
There is one big caveat to be aware of in all of this, and that is the notion that currency fluctuations shift growth and benefits from one country to the next, but do little to grow the whole pie larger. Said differently, the benefits that exchange rates provide to one country come at the cost of others. It’s a case of stealing from Peter to pay Paul.
So while a weaker dollar would favor improving US conditions, it implies more difficult conditions elsewhere around the globe. With approximately 14% of US GDP coming from exports (World Bank), weakness overseas can indirectly impact conditions here, even if the exchange rates move favorably.
Winding up this article, I’d like to comment briefly on the buffering effect that I believe exchange rates play in the global economy.
Currency exchange rates are a mechanism by which growth and prosperity can be shared between nations. Within certain ranges and bounds, they provide a medium through which some countries are penalized, and others benefited, as a result of each nation’s respective strength. The result is a buffering effect that prevents one country from getting too far ahead, while helping the laggards catch up.
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Consider what has recently taken place with the dollar. During this recovery, US economic growth outpaced most of the world. Relative US economic strength led to inflation levels and interest rates both being higher than in many parts of the world, and created lots of value in equity markets. This in turn attracted global investors who bid up the dollar as they purchased dollar denominated assets.
As the dollar rose, it began to negatively impact the economy, and those very same factors that made the dollar attractive began to deteriorate. Economic growth slowed as export demand fell, and inflation headed lower, placing downward pressure on interest rates.
In the meantime, the exact opposite happened elsewhere. Economies that were struggling, such as Europe, saw their currency weaken against the dollar, giving them a needed tailwind. The weaker currency provided them with the economic benefits described earlier in this article, at the cost of countries whose currencies were appreciating (primarily the US).
This effect plays out constantly. Strong economies are rewarded with strong currencies, which penalize them, and weak economies beget weak currencies, which act to pull them up. Obviously there are many other factors at play and bounds within which this process operates, but it’s interesting how the movement of exchange rates acts to disperse economic growth between countries, never allowing one to get too far ahead of the others.
We really are all in this together.
The preceding content was an excerpt from Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
