The Dollar Could Lift Up Your Portfolio, Even If It Drags Down The Economy

The Dollar Could Lift Up Your Portfolio, Even If It Drags Down The Economy
Stéphane Renevier, CFA

almost 2 years ago6 mins

  • A widening difference in interest rates between the US and the rest of the world, the strong performance of American companies, and safe-haven flows all helped push the US dollar higher.

  • A strong greenback isn’t all good news: it increases inflationary pressures elsewhere, stems the global flow of credit, and weighs on other economies.

  • Going long the USD can be a useful hedge against a worsening global growth picture and a more hawkish Fed.

A widening difference in interest rates between the US and the rest of the world, the strong performance of American companies, and safe-haven flows all helped push the US dollar higher.

A strong greenback isn’t all good news: it increases inflationary pressures elsewhere, stems the global flow of credit, and weighs on other economies.

Going long the USD can be a useful hedge against a worsening global growth picture and a more hawkish Fed.

Plenty of global assets have fallen in the past year, but the US dollar isn’t one of them: the greenback is up 15% from a year ago, and that rally’s not showing any sign of letting up. And while that could ultimately end up bringing the global economy to its knees, here’s the twist: the dollar might be exactly what your portfolio needs to see you through.

Why is the US dollar so strong?

US Dollar Index (DXY) at a decade high. Source: Koyfin.com
US Dollar Index (DXY) at a decade high. Source: Koyfin.com

The USD is almost 30% stronger today than it was 10 years ago, and has appreciated 15% in the past year alone, according to the dollar index, which tracks the value of the greenback against a basket of other currencies. Three factors have been behind the rally:

Monetary policy divergence: The Federal Reserve (the Fed) has been one of the most aggressive central banks in raising interest rates to ward off high inflation. With other large economies like Japan or the eurozone still maintaining stimulative monetary policy, this has created a big disparity in interest rates, and that’s led to strong inflows into the US as investors seek out higher yields, pushing the currency higher.

Economic heft: The US economy is one of the most robust in the world and by far the biggest. Some of its companies are the most innovative, adaptable and fastest-growing worldwide. That’s led investors to favor US stocks over those of other regions, generating strong inflows and a strengthening greenback.

Safe-haven flows: The dollar benefits when the US economy outperforms its peers, but it also benefits when the economy is struggling. That’s because US assets are perceived as safe, and investors flock to them when the outlook is darkening. This surprising performance profile – that ability to perform well in both great and terrible times – is known as the “dollar smile.”

Isn’t a strong dollar usually good for the economy?

That’s how it’s typically perceived. A strong dollar reduces import prices in the US, which is good for American consumers, and they’re a powerful force. Simultaneously, it makes exports of foreign countries more competitive, and that boosts those economies. This explains why countries sometimes work to devalue their own currencies versus the dollar.

We’re in an almost opposite situation today, which is why some people are talking about the threat of “reverse currency wars”. You see, the biggest risk to economies now isn’t slow growth – it’s high inflation.

For economies today, a stronger domestic currency is preferable, because it reduces the price of imports and helps offset some of that inflation.

So the strong dollar is a risk?

The strengthening dollar has actually been posing a serious threat to the global economy: by increasing inflationary pressures abroad, it has forced foreign central banks to hike interest rates – sometimes aggressively – and that will likely compound the pressures on growth they’re already facing.

At the same time, a rising dollar has a massive impact on global financial conditions. Since most companies – and many governments, especially in emerging markets – borrow in dollars, when the greenback gets stronger, it adds to their financing costs. And that puts pressure not only on their current financial situation, but also slows their credit creation, which will reduce future growth too.

Put differently, a rising dollar is akin to global quantitative tightening – it’s bad for global growth, and for almost every single asset out there.

That’s not a surprise, then, that some major economic crises happened to coincide with times like these – when the Fed was hiking interest rates and the dollar was rising. The Latin American debt crisis of the early ‘80s, was one, and the Asian and Russian crisis of the late ‘90s, another.

When will the US dollar weaken?

The US dollar will start to weaken when the disparity in key interest rates between the US and the rest of the world shrinks.

Now, if the Fed were to take its foot off the rate hike pedal, it would ease the upward pressure on US interest rates, and allow other economies to breathe. And if that were enough for other economies to handle higher rates without going into full-blown recession, it’s possible that global growth might resume, and capital flow might flow from the US back into global markets, weakening the greenback in the process.

That doesn’t seem particularly likely in the near-term, because the US is fighting sky-high inflation and needs both higher interest rates and a strong currency to win that battle.

What’s more, the only reason why the Fed would be less aggressive with its rate hikes is if the US economy falls by so much that it takes inflation down with it. In that scenario, however, the world will likely also succumb to recession, and investors' sentiment would drive safe-haven flows into US assets, keeping the dollar high.

Barring an extreme event – like a coordinated intervention by major central banks, in which they sell off US dollars to try to deflate its value – the greenback is likely to remain strong at least until inflation and investor worries go away.

So how could you protect your portfolio?

A rising dollar is a major source of risk for the global economy, yes, but it can be a source of strength for your portfolio: by going long the US dollar, you’d hedge the risk of a disruptive decline in global growth.

You’d also protect your portfolio from the risk of the Fed becoming even more aggressive with its rate hikes, which could happen if inflation proves to be even stickier than expected. In that scenario, a long USD position may be the only position that could save your portfolio, as both bonds and stocks would likely suffer. And if the dollar weakens, it’s likely to be a pretty good environment for most assets, so the rest of your portfolio should do well.

You can buy the US dollar via the Invesco DB US Dollar Index Bullish Fund (ticker: UUP, expense ratio: 0.78%), or bet on individual currency pairs via spread bets or other options your broker may propose. The more defensive you want your long dollar position to be, the riskier the currencies you should short it against. Going long the US dollar versus the Canadian dollar, Australian dollar, or New Zealand dollar would be good options in that case.

For those who want to profit from potential weakness in the US dollar, but who also want to remain defensive, the Japanese yen is trading at attractive levels and seems poised to rebound. As we argue here, the yen should be the main beneficiary should the rising dollar prove disruptive. You can either trade it directly versus the US dollar via spread bets, or through the Invesco Currencyshares Japanese Yen Trust (ticker: FXY, expense ratio: 0.4%).

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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