Introduction
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Currency movements drive, and are driven by, economic conditions, and have become more important due to globalization. Given the current and looming trade wars, it is not surprising that Google web search for the dollar is at an all-time high (figure 1), and the dollar has risen strongly this year (figure 2)..
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Changes in the dollar impact earnings, can be used as a weapon, influence inflation, and can affect asset allocation. It is no wonder that it is an often talked about subject.
1. The S&P 500 generates 37.9% of revenues internationally (source: FactSet), so a rise in the dollar hurts earnings (negative relationship, figure 3).
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2. China has devalued the yuan by over 8% this year, effectively more than offsetting the impact of the tariffs enacted by the US (figure 4).
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3. A stronger/weaker dollar makes prices of foreign goods less/more expensive, and thereby influences inflation (negative relationship, figure 5). This is quite important as inflation impacts consumer spending power and Fed policy, which affects the economy.
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4. Movements in currency can even influence the performance of small versus large-cap stocks (positive relationship, figure 6). The Russell 2000 generates only 20.9% of its sales internationally (source: FactSet, BlackRock). Thus, small caps tend to outperform large caps when the dollar
strengthens, like this year. Although, there are notable exceptions such as in 2015 and 2016 when the dollar rose and the Russell 2000 underperformed; perhaps this was because during that time earnings of more domestically and commodity and industrial focused stocks (small, Russell 2000) fell to a greater degree than large more international companies (S&P 500) as the commodity and industrial sectors deteriorated into a “recession.”
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What Drives the Value of the Dollar?
Theories abound as to what drives the dollar, and it is not just dependent on one factor as many people like to focus on in soundbites. However, the drivers are not too complex, and all tie back to the economy.
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For simplicity, in this paper, I just consider the relationship between the US dollar and Euro, but the analysis can be extended to other currencies. Figure 7 shows how my currency model (labeled index) correlates with the dollar/euro exchange rate. As you can see, the model works quite well. It hooked up earlier this year just as the dollar started its rebound. Movements in the currency have a 0.67 correlation with the model (figure 9).
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With the exception of my students who manage a global macro fund, I cannot give away my currency model’s secret sauce (actual variables, weights, how the index is created), but read on as I give you some hints… Figure 8 notes several types of variables in the model and figure 9 shows a correlation matrix between the annual changes in the model’s nine variables (the categories are noted, but the names of the variables are not listed) and yearly changes in the euro/dollar exchange rate. (Important note: the model does not incorporate actions by governments to manipulate currencies.)
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Let’s now take a deep dive and review some of the dollar’s main drivers.
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Economic Growth
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As one country advances quicker than another, it attracts investment and foreign investors. The faster growing country typically becomes perceived as relatively safer. Both effects drive up the value of the dollar.
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Figure 10 shows that the dollar is positively related to relative earnings growth. However, just because the US is growing faster than the world does not necessarily mean that the stocks follow uniformly (figure 11). Remember, a rising dollar will eventually eat into foreign sales and earnings for US companies (figure 3), so US stocks may react negatively (versus foreign stocks) to the increase.
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Currently, the US is experiencing a period of relative rapid growth and this has boosted the dollar, but growth is expected to slow over the next year (see EPS Coming in for Landing When P/E is High).
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Inflation
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Inflation directly eats into the purchasing power of the dollar. If the cost of a McDonald’s hamburger increases 5%, then the US consumer has 5% less spending power per dollar (if he or she eats McDonald’s hamburgers). Higher inflation in one country versus another negatively influences exchange rates. If the cost of the hamburger in Europe rises 2%, while it increases 5% in the US, then the European consumer has extra purchasing power versus the US consumer – the European consumer can purchase about 3% more burgers than the US customer – and the euro should rise relative to the dollar.
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Figure 12 shows how the dollar varies inversely with relative growth in inflation, at least most of the time. That is, when the US inflation rate rises relative to Europe’s, the dollar weakens. The relationship is not perfect because the relative strength of the two economies also influences the dollar/euro relationship (see earlier comments). If inflation picks up (and is not too high) in the US because economic growth is strong, then the dollar could rise instead of fall. This explains the positive correlation in 2003-7 (see the earnings trend in figure 11 and the GDP growth trend in figure 15).
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Inflation has hooked up this year and the dollar is still higher. This means that investors believe higher inflation is temporary, it is not yet a problem to long-term growth and Fed policy, and/or other variables that are driving (better economy) or follow through from higher inflation (higher rates) are having a greater influence on the exchange rate.
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Interest Rates
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Interest rates trends may be the most discussed driver of exchange rates. If rates rise in the US relative to other countries, then US bonds are more attractive than those elsewhere (all else equal). Higher rates will attract foreign inflows and drive up the dollar (figure 13). Of course, interest rates are rising in the US because its economy is relatively strong versus Europe.
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My currency model includes three interest rate factors. Two of the three are directly related to monetary policy, and the third is driven more by market forces (e.g., longer-dated bonds).
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Net Exports
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The current account deficit influences exchange rates. As the dollar strengthens, foreign “stuff” becomes cheaper so US consumers can buy more of it and the trade deficit widens (figure 14). However, the act of buying more of the foreign “stuff” with foreign currency eventually raises the foreign currency’s value relative to the dollar and the dollar’s rise wanes and makes US goods a better deal to foreigners. Thus, the forces of buying foreign goods and services should make the dollar cycle self-correcting.
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President Trump complains just about daily (if not multiple times a day) about the trade deficit, and while the deficit could be partly explained by unfair trade policies, and I support well-conceived policies to make trade fair, it is also likely due to the United States’ relatively strong economy. If the US economy strengthens, relative to others, its citizens are relatively richer and have more of an ability to buy others’ “stuff” than they can buy of the US’s. So, a strong economy leads to a higher dollar and higher trade deficits (figure 15).
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Fiscal Policy
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Finally, fiscal policy influences the dollar. The current direction of Trump’s fiscal policy could hinder Trump’s America First strategy.
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As the government engages in expansionary fiscal policy – running a budget deficit by cutting taxes and increasing spending, like the US is doing now – this pushes up the dollar (figure 16). Remember, this makes foreign goods cheaper and may negatively impact the trade deficit. Thus, Trump’s tax cut may help to widen the trade deficit!
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Expansionary fiscal policy positively impacts the dollar in four ways. First, if successful, it will spur on economic growth (positive relationship to dollar). Second, more debt could cause interest rates to rise (positive impact on the dollar). Third, as noted above, better US growth may drive up trade deficits (positive relationship with the dollar). Fourth, if foreigners fund part of the government’s spending binge, then their act of lending (buying Treasuries) pushes up the dollar. Plus, perhaps to Trump’s chagrin, it may make the US more reliant on foreigners.
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Outlook
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Current conditions set up 2018 for a rising dollar (figures 2 and 17). The economy is strong, interest rates are rising, trade deficits are a major issue, and fiscal policy is expansionary. The only negative for the dollar is rising inflation.
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However, moving into 2019, the drivers become more mixed (figure 17), and bullish positioning has risen (figure 18). Futures traders bet with the trend in the dollar; they tend to become more bullish the further the dollar rises (they do not anticipate), and vice versa. In 2019, growth could slow, but inflation is not expected to slow. If growth slows, long-term interest rates may fail to rise much more, but it appears the Fed is still set on raising short-term rates. Perhaps the trade situation improves, and if it does this would be associated with a declining dollar. Can fiscal policy remain strong? Government spending is rising and does not appear to be about to abate.
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