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Expectations for a Strong U.S. Dollar in 2017 May be Losing Currency
The U.S. dollar moved sharply higher against the world’s major currencies in 2014 and 2015 — creating a strong dollar environment in the truest sense of the term. US investors experienced the results of a stronger dollar in the form of tepid economic and profit growth, and muted inflation.
Despite persistent media headlines to the contrary, the currency backdrop has been more nuanced since early 2016. Indeed, the U.S. dollar, as measured by the Bloomberg Dollar Index, traded in negative territory from mid-February through mid-November 2016, not reaching positive territory until after the November US elections.1
Limited upside for US dollar in 2017?
It has been my team’s position for the past 12 months — contrary to most analysts — that the US dollar holds limited near-term upside potential. In fact, the Federal Reserve’s own minutes have painted a self-defeating paradigm for a strengthening U.S. dollar.2
As the dollar strengthens, it can become more expensive relative to other currencies. This may stunt exports and potentially reduce both economic growth and inflation, which the Fed has been trying for years to support. A modestly stronger dollar in 2017 — say, 2% to 4% higher, may not seem to represent a lethal threat to either economic growth or inflation, given the U.S. economy’s current momentum. But an increase of 5% or more in the value of the dollar could trigger alarms and may cause the Fed to slow the pace of monetary tightening.
Here’s where it could get tricky. If the impetus for a significantly stronger dollar is a hawkish Fed, then a stronger dollar is self-defeating, as such a move could push the Fed back toward a more dovish stance. Such has been the case, we believe, since the Fed’s statements to this effect in September 2015.
With both the economy and inflation on firmer footing than a year ago, and with the Bloomberg Dollar Index up over 4% since the November elections through mid-January, many analysts are predicting that the dollar could rise sharply in the coming year because the Fed could conceivably raise rates at a faster pace in 2017.
But recently, the market got its first look at the minutes from the most recent Federal Open Market Committee meeting, and lo and behold, the Fed again expressed concerns about a stronger dollar — acknowledging that the effects of a stronger dollar could limit the pace of rate hikes in the future.2 Déjà vu. If we are to take the Fed at its word, it’s hard to conclude that the Fed will blindly drive the dollar sharply higher this year. Sure, we may see a steeper rate path in 2017, but, in my view, this will most likely occur within the context of a stable US dollar.
Dollar strength as a function of global rate divergence
It’s important to consider that US dollar strength over the past few years has been based largely on expectations for interest rate divergence. In other words, the strong dollar was not so much a function of higher US interest rates per se, but of expectations that rates would rise relative to those of our trading partners.
Let’s assume for the moment that the Fed hikes rates by 25 basis points two or three times in 2017. How would this affect the dollar? In my view, it boils down to rate divergence. Rates for the euro, Swiss franc and Swedish krona are currently deep in negative territory, but economic growth is steadily rising in those economies.1 Thus, the current tilt to European Central Bank (ECB) policy is to begin moving toward rate normalization. With eurozone two-year yields recently sitting at -0.77%, yields could increase 75 basis points and still remain below zero.1 Under that scenario, if net short-term rate increases in the US failed to exceed 75 basis points, the spread between U.S. and eurozone interest rates might not increase, and could even narrow. Considering recent history, this could mute appreciation in the US dollar.
The unexpected delay in Fed liftoff over the past two years has eaten up a considerable amount of time during which market participants expected more significant rate divergence. As such, the window for widening rate differences between the United States and Europe may now be closing. As if to put an exclamation mark on the approach of that day, the Swedish central bank — the Riksbank — surprised markets on Dec. 21 when three of six voting members voted to halt quantitative easing, or, as one member suggested, to reduce it by half.3 Since then, the US dollar has fallen more than 3% versus the krona in anticipation of the end to the Riksbank’s quantitative easing program.1
Relationship between U.S. dollar, U.S./eurozone yield spreads
Expectations alone could weaken US dollar
This leads to another important point: Markets are often driven by expectations — long before events actually occur. As you can see in the chart above, the US dollar’s appreciation occurred before the Fed’s first rate hike in December 2015. Indeed, the dollar peaked in early March 2015, right before the expected first rate increase, and has moved sideways for almost two years since, as investors wait for signs of more aggressive Fed action.1 The past two years of delay may have eaten up much of the divergence window that originally drove the U.S. dollar higher.
If the market embraces an even modest likelihood that US/European interest rate spreads at the end of 2017 will be no greater than they are today, the prospects for stronger US dollar exchange rates appear uncertain at best.
A flat to weaker US dollar could provide a tailwind to commodities and emerging market equities. Most major commodities are priced in US dollars. So, when the dollar falls in a broad fashion against other currencies around the world, commodities tend to rise in US dollar terms. This maintains commodities’ relative value versus other global currencies against which the US dollar is falling.
With respect to emerging market equities, many such countries’ borrowings are denominated in U.S. dollars. But the local economic activity occurs in the local currency. So, if the U.S. dollar falls in value, then the value of that country’s debt and interest payments fall relative to local currency revenues. This frees up local currency to be spent and recirculated in the local economy, potentially boosting economic growth in that region, which can translate into higher local equity market valuations.
Learn more about the PowerShares FTSE RAFI Emerging Markets Portfolio (PXH) and PowerShares Optimum Yield Diversified Commodity Strategy No K-1 Portfolio (PDBC).
1 Source: Bloomberg L.P., Jan. 11, 2017
2 Source: Board of Governors of the Federal Reserve System — 2016 FOMC Meetings
3 Source: Bloomberg News, Dec. 21, 2016
A basis point is one hundredth of a percentage point.
Inflation is the rate at which the general price level for goods and services is increasing.
The krona (crown) is the official currency of Sweden.
Quantitative easing is a monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective.
Rate divergence refers to the spread between interest rates on government bonds of the same tenor in the US and Europe.
Net interest is the difference between interest earned and interest paid, which gauges how successfully a company, typically a bank, made its investments relative to its debt situation.
Spread represents the difference between two values.
Yield is the income return on an investment.
The European Central Bank (ECB) is responsible for the monetary policy of the European Union.
The Federal Open Market Committee (FOMC) is a 12-member committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.
The US Dollar Index measures the value of the US dollar relative to the majority of its most significant trading partners.
The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.
Preferred ETFs Confront the Fed
Published March 15, 2017
Preferred stocks and exchange traded funds, such as the the iShares S&P US Preferred Stock Index Fund (NYSEArca: PFF), the largest preferred stock ETF, are among the high-yield, income-generating asset classes that have recently come under pressure as investors price in rising odds that the Federal Reserve will raise interest rates today.
Preferred stocks are a type of hybrid security that show bond- and equity-like characteristics. The shares are issued by financial institutions, utilities and telecom companies, among others. Within the securities hierarchy, preferreds are senior to common stocks but junior to corporate bonds. Additionally, preferred stocks issue dividends on a regular basis, but investors don’t usually enjoy capital appreciation on par with common shares.
“The reason company’s issue preferred shares are to raise capital from investors that are seeking an attractive yield without adding traditional debt (bonds) that carry strict maturity dates and covenants. Preferred stocks can also be “callable” from the issuer, who has the right to redeem them at a certain price or time at their discretion,” reports ETF Daily News.
Income investors have looked to preferred stock ETFs in their portfolios for a number of reason. For instance, the asset class offers stable dividends, does not come with taxes on qualified dividends for those that fall into the 15% tax bracket or lower, is senior to common stocks in the event liquidation occurs, is less volatile than bonds and provides dividend payments before common shareholders.
If rates rise, the holdings must decline in price to elevate their yield to attractive levels. Furthermore, most preferred stocks are either perpetual or long-dated, which exposes investors to significant interest-rate risk.
However, despite the Fed’s plans to hike interest rates multiple times this year, we may still be in for an extended low-rate environment as many risks could keep a lid on yields and support safe-haven demand for fixed-income assets.
“Income investors have several attractive preferred stock ETFs at their disposal and new entrants are raising the bar even further. However, the real question is how these funds will react to additional upside in interest rates if that is indeed the prevailing trend throughout 2017,” according to ETF Daily News.
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