Since the 1970s when the Bretton Woods fixed-currency regime ended and currencies began floating, a typical dollar rally has lasted roughly six to seven years . The increase in the dollar we’ve seen so far this year is muted compared with the strong dollar episodes of the early 1980s and late 1990s . The dollar’s recent rally may just be getting started. In addition, according to the BlackRock Investment Institute , dollar rallies tend to be self-reinforcing-a stronger dollar begets greater inflows into U.S. assets in expectation of further dollar appreciation. For instance, U.S. companies start hedging overseas earnings, increasing demand for dollars.
A rocky ride is par for the course
In past dollar rallies, the dollar’s rise is usually not uniform, with lots of dispersion across different currency pairs, and it’s characterized by sharp reversals. According to BlackRock Investment Institute research , history suggests the dollar usually rises moderately before the first Fed rate hike, then stumbles for a year (as fixed income markets often take a hit), before resuming its rally. The same pattern could repeat itself this time around.
Currency Performance – Year to Date
To be sure, for this cycle in particular predicting currency movements requires divining the behavior of the world’s major central banks. The process is further complicated by the fact central bank policy now includes unconventional monetary policies in addition to changes in interest rates.
That said, assuming the dollar continues to appreciate over the longer term, there are several implications for investors. A dollar that remains strong , albeit with some reversals, would put downward pressure on inflation and the earnings of U.S. exporters. Commodities are also likely to struggle in an environment characterized by a stronger dollar and rising real rates.
But further strength in the U.S. dollar would likely be good for equity markets that traditionally outperform on their currency’s weakness, such as Japan and the eurozone, as a stronger dollar will make their exports more competitive. Finally, the long-term strength in the dollar boosts the case for considering strategies that can help insulate an international equity portfolio from the impact of weak foreign currencies, such as currency hedged exchanged traded funds (ETFs).
Sources: BlackRock, Bloomberg
Russ Koesterich , CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog .