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Watch this year’s bounce in the buck

15 May 2018

The fluctuation in the US dollar potentially has huge implications for a range of asset classes, says Russ Mould, investment director, AJ Bell.

The American politician and one-time Treasury Secretary John Connally once remarked to his country’s trading partners (and rivals) that “The dollar is our currency, but it’s your problem” and this year’s bounce in the buck must be watched very closely by investors, as it has potentially huge implications for a range of asset classes – and not all of them are positive,” says

The dollar’s initial decline this year looked odd, given the US Federal Reserve’s gathering determination to try and normalise policy, by both raising interest rates and withdrawing Quantitative Easing QE) under new chair Jay Powell. Sure enough, the greenback now seems to be responding to the monetary medicine and according to the Bank of England’s trade-weighted index the buck is trading at its highest level this year:

The big question now is whether this is represents the next leg up in the dollar bull run that began back in 2011.

If so, it would be the third major advance in the US currency since the so-called Nixon shock and America’s withdrawal from the gold standard and Bretton Woods in 1971, following 1971-1979 and 1985-1995

It would also potentially add a fresh complication to the mix for investors, for four reasons.

1. 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 the broad stock market 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.

2. 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 Asia 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.

Recent weakness in the Turkish lira, Argentinean peso, Russian Rouble, Indonesia Rupiah, the Mexican peso and Malaysian ringgit can be explained away on a case-by-case basis, due to local political or economic developments, but they could also be a harbinger of a shift in risk appetite, away from emerging markets and toward the safer waters of the dollar.

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

4. 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 investors 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.

In all cases, it is hard to divine which is the chicken and which the egg and correlation is guarantee of causation.

But a strong dollar 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.

According to data from the Bank of International Settlements, emerging markets represent one-third of all non-bank borrowing outside the USA that is priced in dollars, with liabilities of nearly $4 trillion.

It won’t take a big fall in their own currencies against the American one to make servicing those debts much more expensive, to the potential detriment of Government and corporate cash flow, and thus economic growth, since interest payments will take precedence over investment.