In the mainstream business media, there are daily discussions about the near-term expectations for the stock market, the outlook on Federal Reserve monetary policy and the direction of long-term interest rates, but only on rare occasions do you encounter a meaningful discussion about currency exchange rates. Now might very well be a time to do just that.
In the second half of 2014, the U.S. dollar rose in value against just about every other major global currency with a few exceptions, such as the Swiss Franc and the British Pound Sterling (see chart 1.0 below). This trend had an immediate and negative impact on the returns earned by U.S. investors on their international investments.
As we reach the mid-way point of the first quarter of 2015, the trend has leveled off to a certain extent, but the U.S. dollar continues to hold at levels not seen for nearly ten years.
Having worked daily in the currency markets for a number of years before joining JoycePayne Partners, I can share that the single biggest factor in the level of exchange rates is relative movement in short-term benchmark interest rates. Other factors, such as tax policy, economic development, natural resource availability, demographics, fiscal policy (or lack thereof) and trade policy, drive the movement of exchange rates as well but these factors tend to play out over years – not months.
What is behind this move? The simple answer is divergence in monetary policy. As is well publicized, the U.S. Federal Reserve is expected to begin raising short-term benchmark interest rates later this year, possibly as early as June. This expectation contrasts with other central banks around the world who are engaged in aggressive efforts to make monetary policy more accommodating. With short-term interest rates expected to rise in the U.S. and fall elsewhere, capital is flowing toward U.S. reserve deposits and other fixed income assets.
What are the investment implications? As the largest, most liquid market on the planet, currency exchange rates are highly mean-reverting but they also tend to over-shoot in the short run. Foreign currency is a zero sum game. Wherever one currency is rising in value others are falling. You have a winner and a loser. Real economic constraints eventually put the brakes on one-way trade which leads to a trend reversal as capital flows in the opposite direction. As a U.S.-based investment firm with the majority of our clients saving and spending U.S. dollars, a strengthening exchange rate lowers the value of existing international investments and cash flow, but it also provides a great opportunity to buy with additional purchasing power. Just like planning a trip to Europe when the Euro is weak, allocating new monies to these markets adds the potential for excess return when the trend inevitably reverses. The challenge is remaining patient. Trend reversals can take some time to unfold, but they are largely predictable as the real economic implications begin to weigh on short-term movements.
What is preferred: a strong currency or a weak currency? The best answer for all participants in the global economy is stable currency exchange rates. Unfortunately, factors come into play that drive monetary policy authorities and governments to enact short-sighted actions to attempt to garner an advantage versus other market participants. For countries that rely heavily on exports for economic growth and tax revenues, a relative weaker currency can help make goods and services more attractive. Unfortunately, this advantage might only last a short while until other nations adjust policy to account for it. The downside of a weaker currency is the potential for rising inflation as imports cost more and foreign denominated debt becomes more burdensome. A rising exchange rate, on the other hand, helps keep inflation subdued but it also places a premium on exported goods and services, which negatively impacts domestic economic growth.
We have experienced numerous rounds of currency manipulation over the years since the breakdown of the gold standard in 1971. The current episode is likely to continue as policies adjust to new realities, but limits will eventually be reached and the trends will begin to reverse. For long-term U.S. investors this period offers an opportunity to build up international assets across all asset classes while the best overall outcome for all countries, especially those more dependent on exports, is faster growth and avoidance of a deflationary spiral.
Given the on-going nature of the newest round of “currency wars,” this is likely a topic you will hear us discuss more frequently than normal. And, by the way, if you are looking at traveling to Europe, now might be an opportune time to book that trip.
Jack E. Payne, CFA, CFP
Chief Investment Officer