All hail the declining dollar

The American politician John Connally packed a lot into his life, including a rare switch from the Democratic to the Republican Party, but he is best known for two things.

First, he was sat in the same limousine as John F. Kennedy when America’s thirty-fifth President was assassinated in Dealey Plaza, Dallas Texas in November 1963.

Second, as Treasury Secretary to President Richard M. Nixon, he oversaw America’s withdrawal from the Bretton Woods monetary system and the gold standard in 1971. This move reintroduced the concepts of floating currencies and paper money without any backing. It also led to an initial period of marked weakness in America’s currency, which prompted Connally to declare that “The dollar is our currency, but it’s your problem” as the US sought better trade terms and a lesser share of global defence and foreign aid expenditure.

Although the buck now trades much lower than it did in 1971 there have been three huge bear markets in the dollar since the so-called ‘Nixon shock’ (1971-1979, 1985-1995 and 2002-11) and three huge bull runs (1979-1985, 1995-2002 and 2011-2016).

Dollar has seen three big multi-year advances and three big multi-year drops since early 1970s

Source: Bank of England

This makes the latest period of dollar weakness particularly interesting. Even though the US Federal Reserve is tightening monetary policy much more assiduously than the Bank of England, the European Central Bank or the Bank of Japan, and looking likely to do more than any of its global counterparts in 2018, the greenback is losing ground.

Dollar has been weak despite tighter Fed policy

Source: Bank of England

This has potential implications for advisers’ and clients’ portfolios, although basing asset allocations on the basis of currency movements alone is likely to be a mug’s game, given the unpredictability of the foreign exchange markets.

Dollar dive

Limited data availability is a bit of an obstacle but in general the following observations can be made, using a dollar index provided by the Bank of England. (An alternative index for the dollar, known as DXY, or ‘Dixie’, can also be used and tracked quite easily).

  • Real dollar strength has tended to coincide with times of uncertainty or even outright financial market stress (such as 2001-03, 2008-09 and even during this decade’s eurozone debt crisis).
  • Global stocks eventually came a cropper after a period of sustained dollar gains in 2000, thrived on the weakness of 2002-07 and then plunged again as the buck briefly soared in 2007-09. All of this makes advances forged this decade appear like an interesting outlier, although a rising dollar did not immediately interfere with the bull market of the late 1990s.

Global stocks have managed to shrug off dollar strength during this decade

Source: Bank of England, Thomson Reuters Datastream

  • Emerging stock markets have been particularly sensitive in the past to the greenback, falling when the buck bounces and gaining when it rolls over. Dollar strength preceded the 1982 Mexican debt crisis, 1994’s so-called ‘Tequila crisis,’ also in Mexico, the Asian and Russian debt and currency collapses of 1997-98 and also heralded a period of deep Emerging Market (EM) equity underperformance relative to developed arenas in the first half of this decade. Recently EM fund managers have spent a lot of time convincing themselves and their customers that dollar strength is less of a problem now, as EM companies have a better balance between their assets and liabilities, but for the moment these finer points seem to be of less interest than before.

Emerging market equities have historically preferred a weaker dollar

Source: Bank of England, Thomson Reuters Datastream

  • Commodities have tended to do better during periods of dollar weakness and less well during periods of greenback gains.

Commodities have historically preferred a weaker dollar

Source: Bank of England, Thomson Reuters Datastream

  • Global government bonds have overall done best during times of dollar strength, as have global corporate bonds. Although the relationships are by no means clear-cut, this makes sense, if advisers and clients accept the thesis that a strong dollar heralds – or is symptomatic – of a ‘risk off’ period in markets, where dependable yields and capital safety are more likely to be highly prized. That said, Government bond yields are rising (and prices falling) as markets price in faster global growth and address the possibility that inflation may finally start to accelerate.

Government bonds appear to have done better during periods of dollar strength

Source: Bank of England, Thomson Reuters Datastream

Commodities have historically preferred a weaker dollar

Source: Bank of England, Thomson Reuters Datastream

  • High-yield, sub-investment grade traded debt has apparently preferred a weaker buck.

Commodities have historically preferred a weaker dollar

Source: Bank of England, Thomson Reuters Datastream

Conclusions

In all cases, it is hard to divine which is the chicken and which the egg and correlation is no guarantee of causation.

But these trends make sense in that a strong dollar is generally seen as deflationary because it makes dollar-priced commodities more expensive for non-dollar-based buyers, compressing their ability to spend elsewhere, and makes it more expensive for non-dollar nations and companies to service any debts they have that are denominated in the US currency.

Dollar weakness could also lift the US economy, as it gives exporters a competitive edge at a time when they are also basking in the glow created by tax cuts. And since America is the world’s biggest economy this may be no bad thing either and it may be the dollar strength, as advisers and clients seek a haven or a bolt-hole, could be a subtle sign of trouble ahead, even if such a sign appears to be lacking at the moment.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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