A strengthening U.S. dollar, now near its highest level since 2009, has important implications for investors.
A new report released by the Schwab Center for Financial Research, a division of Charles Schwab & Co., examines exactly what those implications might be and suggests practical advice for investors in a rising dollar environment.
As the report states, the U.S. dollar has appreciated by more than 7% on a trade-weighted basis since May.
“We believe the dollar is entering a longer-term uptrend that could last a year or longer,” said Kathy A. Jones, vice president and fixed income strategist with the Schwab Center for Financial Research, in the white paper.
Jones attributes being bullish on the U.S. dollar to the performance of the U.S. economy compared with other major countries.
“Over the past year, the U.S. economy’s GDP growth rate has picked up, while growth is floundering elsewhere,” she says in the white paper. She then points to estimates that show “the U.S. economy will expand at a 3.1% pace in 2015 compared with 1.3% for the eurozone and 0.8% for Japan.”
Emerging market countries are also slowing down, Jones says. The GDP growth among this group is estimated to be 4.4% this year, which Jones says is the lowest since the financial crisis.
“With stronger growth, U.S. interest rates — even at current paltry levels — are significantly higher than those in core European countries or Japan, making the dollar more attractive for investors to hold,” Jones writes.
Jones says a rising U.S. dollar means that U.S. bonds are likely to outperform international bonds from developed countries and emerging markets, and commodities are expected to underperform — which is why she suggests reducing exposure to international developed country bonds and emerging market bonds and commodities.
“If the dollar continues to appreciate, then the return on foreign bonds is likely to lag behind the return on U.S. bonds,” Jones writes, adding, “This is especially true in the developed country bonds, where yields tend to be lower than in the U.S.”
She says U.S. bonds will likely outperform even among the countries with higher bond yields, such as Australia, because “the yield spread versus U.S. bonds is relatively low compared to a year ago and may not compensate for the risk of a further decline in the currency.”
While emerging market bond yields are higher than in developed countries, Jones points out that the emerging market currencies tend to be more volatile, which she believes could have a bigger impact on the total return of a bond investment.
“We believe the exposure of many [emerging market] countries to a global slowdown is higher than it is for the U.S.,” Jones states in the white paper. “While every country is different, on average EM countries rely more heavily on exports as a percent of GDP growth than does the U.S. Since the currency component of total returns in EM bonds can be significant, they are likely to underperform U.S. bonds in a rising U.S. dollar environment.”
Despite all this evidence, Jones is also quick to point out that this investing idea is not fail-safe. “While we believe reducing exposure to foreign bonds when the dollar is rising makes sense, there are risks to consider,” she says.
For example, by reducing exposure to international bonds in a portfolio, the investor loses some of the diversification that international bonds offer. Or, Jones says, global growth could rebound more than anticipated, which would cause the currencies of those countries to rise relative to the U.S. dollar.
Jones also admits that she could be wrong in her expectations of a bull market for the dollar.
“The path of the U.S. dollar is not certain,” she says, adding, “The Federal Reserve might hold off longer on tightening monetary policy than current market expectations suggest, which might result in a weaker dollar.”
The last time the dollar experienced a long-term surge was during two major bull markets, from 1979 to 1985 and 1995 to 2002.
The dollar nearly doubled from 1979 to 2002, and Jones said a key driver during that bull market was the high U.S. real interest rates because the Federal Reserve was fighting inflation at the time and U.S. interest rates soared, which attracted foreign capital to the U.S. markets.
The second major bull market, from 1995 to 2002, was driven largely by the technology boom in the U.S., which boosted economic growth and drew in foreign investment to U.S. markets. This bull market ended when the tech bubble burst.
—Related on ThinkAdvisor: