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The Dollar’s in the Dumps: What Does It Mean?

February 2018
By Nanette Abuhoff Jacobson

What does the greenback’s surprising weakness ultimately mean for investors?

 


 

Over the past several quarters, the US dollar (USD) has depreciated sharply, despite rising interest rates (FIGURE 1). This divergence is anomalous—rates and the dollar are normally positively correlated as higher rates attract flows to US assets.

 

FIGURE 1

The dollar is falling despite higher US interest rates

MFGS_021518_1

Source: Bloomberg

 

Many explanations have been floated for the greenback’s slide, including rising US debt, better growth prospects outside the US, and political dysfunction in Washington. In my view, however, the dollar’s recent behavior appears more closely related to the flattening of the US yield curve. 

A flatter curve has historically portended recessions, which usually decrease the value of the dollar. Today, the US yield curve has flattened relative to Europe and Japan, which the market seems to be interpreting as a signal that the US is nearing a recession.

I believe the market is overreacting to the prospect of a US recession, and that four factors are likely to prevent the yield curve from flattening further:

Positive nominal growth: A combination of faster US growth and higher inflation should elevate long-end yields*

Rate hikes: The Federal Reserve (Fed) is likely to move slowly in hiking short-term interest rates

Fed balance-sheet runoff: According to the Fed, quantitative easing has lowered long-end yields by about 1 percentage point; tapering should reverse that

US Treasury supply: The US Treasury Department is likely to issue more long bonds; this increased bond supply could lead to higher long-end rates

If the US yield curve stabilizes or steepens, as I expect, the dollar should begin a gentle appreciation versus the euro and yen, particularly as the Fed hikes interest rates while the European Central Bank and the Bank of Japan continue with quantitative easing.

Investment Implications 

Near term

  • I favor US equities: A weaker dollar makes US goods relatively attractive, and overseas sales in stronger currencies boost USD-denominated income statements
  • I favor emerging markets (EM) equities and local debt: A weaker dollar would be a tailwind for these assets, lowering the cost of USD-denominated debt and helping attract flows into EM

Longer term

  • I favor European equities: The European economy is growing faster than the US, valuations are cheaper, and the euro should stop appreciating
  • Japan should also be attractive: Japanese monetary policy is still very accommodative, and valuations are lower than in the US. Furthermore, if the US yield curve stops flattening, the yen should depreciate versus the dollar, providing a tailwind for Japanese companies.
  • I favor developed over emerging markets: Eventually, if the US dollar stabilizes, I would favor developed markets where growth is relatively strong and volatility is lower

1 The US Dollar Index is a geometrically-averaged calculation of six developed market currencies weighted against the US dollar.

* 10+ years maturity

All investments are subject to risk, including the possible loss of principal. Fixed Income risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall; these risks are currently heightened because interest rates are at, or near, historical lows. U.S. Treasury securities are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. Foreign investments can be riskier and more volatile than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as political and economic developments in foreign countries and regions (e.g., “Brexit”). These risks are generally greater for investments in emerging markets.

The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

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