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Friday, March 29, 2024

U.S. Dollar Still Stands Tall – LPL Financial

By VW Staff. Originally published at ValueWalk.

U.S. Dollar Still Stands Tall by LPL Financial

Key Takeaways

  • As the currency of the world’s largest economy and largest exporter, the dollar naturally plays a dominant role in international transactions.
  • We expect the dollar to remain the dominant global currency for the foreseeable future.
  • The likelihood that the Fed begins to hike rates by December 2015 suggests continued dollar strength.

U.S. Dollar Still Stands Tall

The U.S. dollar remains strong, defying some skeptics. As has been the case since late 2008 when the Federal Reserve (Fed) began its quantitative easing (QE) program, there has been a great deal of concern recently among some market participants that the dollar is on the verge of a significant decline. Although the dollar may have lost some market share relative to other global currencies in recent decades, it remains the dominant global currency (often referred to as a reserve currency) and we expect it to remain so for the foreseeable future.

Why All The Attention?

The U.S. dollar is getting a lot of attention these days for many reasons. The dollar’s strength this year (+7% year to date based on the DXY U.S. Dollar Index) has had a negative impact on earnings for U.S.-based multinationals and contributed to fears of an “earnings recession” (not our expectation). Commodities, which trade in dollars globally, have been under pressure from the dollar’s strength beyond the impact of fundamental factors such as the slowing Chinese economy and oil’s high-profile global supply glut. Finally, some are worried that the dollar may lose its place as the leading reserve currency, which we discuss below.

The dollar matters, as we acknowledged in our Weekly Market Commentary, “Dollar Strength Is a Symptom, Not a Cause” (March 16, 2015), and there are legitimate reasons to pay attention to it. But a look at fundamentals suggests nothing more than a slow, gradual decline for the dollar over a very long period.

Relative Game

Before making the case for “King Dollar,” as Larry Kudlow and others have referred to it, keep in mind currencies are a relative game. The dollar’s moves are dependent upon the other leading global currencies, which are driven by economic growth, interest rates, and inflation, among other factors, in these various countries and regions.

For example, U.S. Treasury yields are very low by historical comparison right now, which could be viewed as bearish for the dollar. But because currencies are relative and U.S. rates are high compared with yields in Europe and Japan [Figure 1], U.S. rates may actually be contributing to dollar strength. Many central banks are pursuing looser policies than the Fed, which, in some respects, is canceling out the impact of the Fed’s monetary support for the U.S. economy on the dollar.

Currency risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.

U.S. Dollar

In the near term, monetary policies of several other major economies contrast with that of the U.S. and may continue to provide support for the value of the dollar in world markets. The Fed is preparing to raise interest rates, while many central banks around the globe are doing the opposite and lowering interest rates, or are clearly focused on maintaining interest rates at very low levels. Among our largest trading partners, both the European Central Bank (ECB) and Bank of Japan (BOJ) are aggressively easing and, in the case of Japan, may do more. The Bank of England (BOE) maintains a zero interest rate policy and may not begin to raise rates until well into 2016. The central bank of our largest trading partner, the Bank of Canada, looks to be on hold for the foreseeable future with a bias toward more easing, as Canada’s economy struggles along with other commodity-producing nations. The likelihood that the Fed begins to hike rates by December 2015 suggests continued dollar strength.

Strong Trade Position

Another concern raised by those worried about the U.S. dollar is that countries with large holdings of Treasuries (and therefore dollars) like China, Japan, and, to a lesser extent, Russia, will suddenly sell all of these holdings in the open market for either political reasons (disagreements with the U.S.) or economic reasons (loss of confidence in the U.S. economy, the Fed, Congress, etc.). Our view remains that a major shift in China’s, Japan’s, or even Russia’s holdings of dollars and Treasuries is unlikely given the tight trade linkages between the countries. In addition, some countries fear the impact on their own currencies and export markets if they sell dollars, especially where growth is uncertain. Over years and decades, foreign economies are likely to continue to move away from the dollar and Treasuries?—?a trend that has already been in place for some time now, the dollar losing ground against major trading partners since the early 1970s?—?but a move out of dollar holdings all at once would not be in the best economic interest of the selling country.

In addition, as the world’s largest exporter, the U.S. produces many

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