- Currency movements can be easily explained through macro trends, but the timing isn’t that precise. However, long term investors can reach additional returns by following a few easy steps.
- Cyclical currency patterns are natural, and under the influence of economic growth in the long term.
- The dollar is approaching its peak and is ready to return to its historical mean.
In last weekend’s Sunday Edition, Investiv Founder, Shane Rawlings, elaborated on how long term macro trends inflect exactly at the moment when there seems to be a general consensus that the trend will last for a long, long time.
Nobody was buying stocks in 1981 because they thought high inflation would stay around forever. On the other hand, in the 1990s, people were convinced that the best investment was internet stocks. And in the 2000s, the conviction shifted to the real estate market as it seemed that the only way to go was up forever.
Currently there is a strong conviction that the U.S. dollar is going to strengthen as interest rates rise and the U.S. economy grows, and while Europe continues with monetary easing.
The currency issue is of essential importance for your portfolio as it can add huge returns and lower risks if you are smart about it.
In today’s article, we’ll discuss how to position yourself, look for currency inflection points, and I’ll elaborate on the necessary investment psychology to make currencies work for you.
Impacts On Currency
What impacts a currency is a mix of factors including inflation, economic growth, risk, perceived stability, trade deficits or surpluses, and interest rates.
A long-term view on the value of the dollar and interest rates shows how interest rates weigh heavily on the currency. As interest rates have been extremely low for a while, the recent and expected hikes really pushed the dollar higher, especially as the ECB kept rates close to zero.
Figure 1: U.S. dollar, the federal funds rate and the ECB interest rate. Source: FRED.
The two red circles show that when ECB interest rates are higher than the FED’s, the dollar weakens and that when the ECB lowers rates, the dollar appreciates.
The current market perception is that the FED will continue to increase rates while the ECB will continue to ease. Market participants and analysts plot the past into the future and expect an even stronger dollar. However, the cheap Euro and the strong dollar do good things for the Euro economy as everything is cheaper and we should soon see the ECB start with tightening, this is especially true considering inflation has started to pick up.
Figure 2: Euro area inflation. Source: Trading Economics.
We can’t know when the current trend will inflect, but as the European economy gets stronger and more competitive, sooner or later the trend will shift and the opposite will hold. Such a cyclical pattern is natural and will continuously repeat itself throughout time.
Another look at the dollar index will show you how this has worked in the past.
Figure 3: Trade Weighted U.S. Dollar Index: Major Currencies. Source: FRED.
Currency cycles have the tendency to evolve over a period of 15 years, but the time frames where the dollar appreciates or depreciates are relatively short with extreme volatility. As the dollar started appreciating in April 2011, history suggests a reversal isn’t that far away. However, the dollar might get stronger for a while and then crash. It’s impossible to exactly time when this will happen, but it will happen as the long term structural trend for the dollar as a currency is negative. This is due to economics.
Economics & Currency
The U.S. economy has been growing at an ever-slower pace for the past 30 years. Emerging markets have been growing at much faster rates. This discrepancy makes the dollar weaker and emerging currencies stronger, and the trend will remain as such until there is more equality globally.
Figure 4: U.S. GDP growth from 1974. Source: Trading Economics.
Further, nobody is contemplating a recession now, but we also don’t have an historic precedent to see how an economy can pull itself out from a long period of zero interest rates. Well, we have the Japanese example which isn’t at all positive.
Risk & Currency
Another factor that impacts a currency is risk. The U.S. is the lender of last resort and therefore the dollar remains strong. But as global economies grow at a faster rate and become global players, this riskless perception of the U.S. will also change.
We can already see it happening. Who would have ever imagined that the Bulgarian 10-year note in Levs or Thai in Bahts would have a yield lower or close to the 10-year U.S. treasury?
Figure 5: Ten-year government bond rates by currency on the 1st of January 2017. Source: Damodaran.
What’s pushing the dollar higher is the fact that other safety currencies like the Yen, Euro and Swiss Franc have zero or negative yielding bonds. When that changes, the dollar will weaken.
Don’t Forget Inflation
A very important factor when investing in another country is inflation as the currency will probably depreciate in relation to the inflation rate. So always discount for the average and expected future inflation when analyzing a specific investment. However, inflation rates are extremely low globally except for Brazil and Russia, but that might also change soon.
Figure 6: Inflation rates per country with long term highs and lows. Source: Trading Economics.
Conclusion & Investment Approach
The best way to take advantage of currencies is to rebalance. When a currency looks strong, it’s time to sell it and buy into a country with a weak currency but stable long term outlooks. The stable long term outlook is essential as you don’t want to invest in some extreme inflationary environment where your investment ends up worthless.
The minimum risk can be achieved by rebalancing between the dollar and the euro. For example, if you own a U.S. utility, you can exchange it for a European one when the dollar is strong and reverse the action when the Euro is stronger. In doing so, you keep getting the income utilities usually provide, but increase returns as you add the benefits of international diversification.
There is still some room for the dollar to strengthen, but it now seems like a good time to start rebalancing.
Figure 7: EUR/USD. Source: Trading Economics.
Apart from currency rebalancing, there are other important rebalancing possibilities so keep reading Investiv Daily to learn how to lower your risks and increase your returns as tomorrow we’re talking more about rebalancing.