The Weak Dollar & Your Portfolio

January 22, 2018

The Weak Dollar & Your Portfolio

  • It’s important to differentiate between short term currency speculation and economic trends.
  • The main global currencies don’t show long term strength.
  • You can rebalance globally, but also protect yourself by owning assets.



Introduction

Many were expecting an even stronger dollar going into 2018 as the U.S. economy is doing well and the FED is expected to raise rates three times in this year, if not more. However, the dollar significantly weakened in 2017.

Figure 1: U.S. dollar index. Source: FRED.

So the dollar has lost about 10% in the last 12 months, but it really depends on how you look at it and there is a great lesson hidden here. If we look at it from a 4-year perspective, or since it was clear that the FED was about to start with higher interest rates, the dollar has strengthened 12%.

The first takeaway here is that there is a big difference between economic fundamental trends and speculation. If you look again at the figure above, the main dollar gain happened from July 2014 to March 2015 which was a straight upward trend. Consequently, the dollar has moved sideways since then. So speculators try to anticipate what will happen and play the trend. This usually creates short term overreactions that consequently lead to reversals. However, the dollar is stronger than it was 4 years ago and it will probably continue to strengthen as the FED raises rates.

Now, similarly to the 2014 dollar appreciation situation, the euro declined back in 2014 and has been appreciating lately as the ECB announced the ending or the phasing out of its bond purchasing program.

Figure 2: USD vs. EUR in the last 5-years. Source: Bloomberg.



So we have strong short term trends and on the other hand we have fundamentals. The question is whether Europe can actually handle a stronger euro or potentially higher interest rates. Fundamental investors have to see the difference between what the ECB president Mario Draghi is saying and what the actual facts are. A stronger euro will impact exports and the competitiveness of the European economy which is mostly competitive because of negative interest rates.

The 10-year yield on an Italian bond is just 2% and we all know that Italy is famous for its fiscal diligence and strong financial policies.

The Italian public debt is 2,283 billion euro and if we estimate a 2% interest yield on it, the yearly interest cost is about 44 billion euro. Now, if interest rates would just go to 4% for Italy, its interest costs would double and its budget deficit—which is now at 2.4%—would also probably double and reach almost 5%. Therefore, one must be very careful when betting on the strength on the euro. Short term fluctuations will always be present and should be taken advantage of to rebalance across currencies in a well diversified global portfolio but one should always keep the fundamentals in mind.

The question now is: Will the dollar continue its decline in 2018?

It’s important to look at such things because if there is a higher probability for a further weakening, then international diversification still pays but if the dollar will get stronger, then it pays to sell some international assets and buy domestic assets instead. Similarly, if you are from Europe, should you diversify globally now that the euro is relatively stronger or wait?

I wish I could know what will happen in the short term, but that is something impossible to forecast. It’s expected that the FED will raise rates three times this year. This should push U.S. yields higher and increase the demand for the dollar. However, if the FED increases rates only two times, we could expect more negative sentiment surrounding the dollar. The key lies in constant global rebalancing and asset protection.



Global Currency Rebalancing

Mere mortals cannot trade currencies because it’s impossible to predict what will happen. The only way to go about it is to attach portfolio weights to various currency exposures and rebalance accordingly.

You might think that fundamentals help you, but the fundamentals of the most important global currencies all look shaky. The U.S. has piled up government debt and has an economy based on consumer debt, the European Union has an economy based on free money from the ECB, Japan has an economy based on even more free money from the BOJ, while China has an economy based on extreme amounts of credit and shadow banking.

Which currency will be the winner in the future? Nobody knows. What can be done is to look for safety in smaller currencies like the Swiss franc which is something we will cover in future articles, so keep reading Investiv Daily. Further, owning producing assets might be the smart way to go now as in case of global inflation due to weak currency fundamentals, you are protected.