ETF Trends
ETF Trends

As the end of 2014 approaches, a few key themes are becoming evident: an unexpected drop in interest rates, the relative strength of the U.S. economy and the rally in the U.S. dollar. The dollar, as measured by the U.S. Dollar Index, has rallied roughly 10% from its spring lows and now stands at the highest level since June 2010. Relative to the Japanese yen, the dollar is trading at its best level since December 2007.

The recent rally can be attributed to a number of factors including a relatively solid U.S. economy, diverging central bank policies (the U.S. is preparing to tighten while the European Central Bank and the Bank of Japan are easing), and long-term changes in trade flows, particularly around the energy sector. We expect most of these trends to continue, and here are three key implications of a rising dollar:

1. Headwind for commodities and inflation. Commodities are priced in dollars, so a stronger dollar translates into lower commodity prices. But there is another transmission mechanism at work as well: real rates. Relative strength in the U.S. economy is not only pushing the dollar higher, but is likely to lead U.S. real rates modestly higher. Historically, higher real rates have further hampered commodity returns—particularly for precious metals—as they raise the opportunity cost of holding an asset that produces no income.

2. Support for the U.S. consumer. A stronger dollar reduces U.S. import prices and lowers inflationary pressures. In an environment of low wage growth, this helps purchasing power.

3. Tailwind for certain international exporters. A stronger dollar is the flip side of a weaker euro and yen, which should prove advantageous for exporting companies based in Europe and Japan.

It is also worth highlighting where the dollar rally may not be as relevant. First, there is a perception that small capitalization stocks tend to outperform the broader market when the dollar is stronger. The theory is that small caps, which are more likely to be domestically focused, should be more immune to a stronger dollar than large companies, whose exports become less competitive when the dollar is appreciating. While a logically sound argument, there is no historical evidence that relative returns between small and large caps are correlated with movements in the dollar.

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