The dollar is on a roll that could help propel the United States economy into a consistent growth mode for the first time since the financial crisis began seven years ago.
Bolstered by structural, cyclical and valuation-based factors, the dollar could be in line for a long-term uptrend, similar to what occurred in the late 1990s, which proved quite beneficial for the markets and economy.
Factors supporting the rising dollar include the prospect of increasing interest rates in the U.S. versus falling rates in other developed economies, the strengthening of the U.S. economy relative to other economies, falling commodity prices and overall low global inflation. Additionally, both the budget and trade deficit have been improving the last few years, adding further tailwinds. Overall, a stronger dollar tends to be supportive of the U.S. economy and the role of the consumer.
While there is plenty of good news potentially associated with any sustained increase in the value of the dollar, there are also negatives. These include the reduced competitiveness of U.S. exports, rising trade deficits (except for energy) and an increased cost of capital and capital flight for emerging market countries. In this commentary, we’ll discuss the factors behind the rise of the U.S. dollar and its potential impact on the U.S. and global economy.
Backdrop to the Dollar’s Rise
On a long-term basis, the dollar has been in decline for decades (fig. 1). In comparison to other major global currencies, the dollar’s value peaked in 1985, and despite a few uptrends – notably in the late 1990s, 2008-09 and 2011 to the present date – its value has settled in a much lower range versus the other currencies during the past 30 years, according to the Federal Reserve Bank of St. Louis. In fact, the real effective value of the dollar is close to a 40-year low.
The lows seen since the financial crisis – with the exception of a brief period in 2008-09 when a flight to quality supported its value – have been a reflection of the Federal Reserve Board’s zero-interest rate and quantitative easing policies. Low interest rates, especially rates that are negative when accounting for inflation, tend to negatively impact the value of a nation’s currency. A stop-and-go economy, which has been growing anemically since the recession ended in 2009, has also been supportive of a weak dollar.
However, through mid-September, the dollar rose for 10 consecutive weeks versus a broad basket of currencies (fig. 2). With the Fed removing liquidity from the economy and poised to increase short-term interest rates in 2015 for the first time in nine years, short rates are likely to rise, which, in combination with a strengthening economy, are dollar positive. The state of the global economy and global rates are also favorable for the dollar. Central Bank policies in other developed economies – specifically Europe and Japan – are loose, favoring low rates there, as both inflation and commodity prices are falling. Emerging economies, while still growing faster than developed economies, are slowing, led by China. These trends are occurring while the U.S. economy is strengthening, feeding a virtuous cycle that could continue to reinforce itself, resulting in sustainable economic growth and a stronger dollar.
Reflecting these trends, capital is flowing into the U.S. economy and markets. According to EPFR Global, from Jan. 1 through Sept. 10, investors put $111.6 billion into U.S. stocks and bonds, compared with $89.4 billion in the same period in 2013.
There are many potential positive implications of a stronger dollar, including:
Weaker commodity prices | A rising dollar tends to result in lower commodity prices because commodities are priced and traded in dollars. As the value of the dollar increases, commodities become more expensive for buyers overseas, who must convert their weaker currencies into dollars. This can also curb demand for commodities, pushing prices even lower.
Lower inflation | Weaker commodity prices and excess economic capacity in the developed world economy continue to anchor inflationary pressures. A stronger dollar, as noted above, acts as a brake on prices of imported goods, which should translate to lower inflation and potentially help keep interest rates lower for longer.
Improved consumer spending | Lower commodity prices leave consumers with more to spend as less of their income goes toward oil, gas and food. In addition, a stronger dollar results in lower prices for other imported goods, such as cars. Lower inflation, another potential by-product of a stronger dollar, is also a plus for consumer spending.
Higher real U.S. GDP growth | Since consumer spending makes up more than two-thirds of gross domestic product, any sustained increase in consumer spending is likely to have a positive impact on GDP growth, which could help the economy break out into a sustained pattern of growth. Higher consumer spending is likely to outweigh the reduction of exports a stronger dollar will have, especially as the level of oil imports continues to fall as the U.S. produces more and more of its own energy.
Just as with any other economic event, a stronger dollar has some downsides, which include:
Larger trade deficits | When the dollar rises, the prices of goods exported from the U.S. become more expensive versus goods produced overseas. This will likely affect the U.S. trade deficit as the prices of imported goods fall and exported goods rise. It will also impact large U.S.-based multinational companies that derive a good portion of their revenues from exporting U.S. goods overseas. This could likely render U.S. manufacturers less competitive than manufacturing companies operating in other countries.
Emerging market issues | With yields low across developed economies, cash has flooded into emerging market economies, and those governments have also had the opportunity to borrow money at low rates. The double whammy of a rising dollar drawing capital away from emerging markets into U.S. markets and higher debt payments is likely to result in lower growth rates for emerging markets at a time when those currencies and growth rates are under pressure already. Emerging market countries will likely have to increase rates to fend off further capital flight, placing growth under further pressure.
Because the dollar is strengthening from such a low level, many economists believe it has room to run with the potential to continue to rise in the short and medium term. As the Federal Reserve begins to move toward a full stoppage of quantitative easing in October 2014 and higher interest rates (summer 2015?), much of the rest of the developed world is in the opposite position – falling interest rates with weakening economies.
This means that more capital is likely to flow toward the U.S. in search of higher rates, as well as more stable and higher economic growth. This could lead to a buffer on higher interest rates and potentially higher equity valuations. And with global geopolitical instability potentially worrying investors after a summer that saw increased conflict in the Middle East and in Ukraine, the U.S. is likely to benefit from its perception as one of the few places where stable economic growth is occurring.
Source: Northwestern Mutual
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