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Are Investors Overestimating the Dollar?

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Michael Arone, chief investment strategist for State Street Global Advisors’ U.S. Intermediary Business, doesn’t deny there is an overwhelming bullish sentiment on the dollar among investors.

But, he admits he’s skeptical that it will continue its meteoric rise. Arone suggests investors may be overestimating the potential growth of the U.S. dollar.

“According to the consensus, the sky’s the limit for the dollar,” Arone says. “Yet … I wonder if the conventional wisdom is wrong and how investors could be impacted if that’s indeed the case.”

In the past eight months, the U.S. dollar has appreciated on a trade-weighted basis faster than during any similar period since the end of Bretton Woods, the fixed exchange rate regime that held sway over global currency markets from 1945 through 1971.

“The dollar has climbed consistently higher since 2011, and I am now skeptical of the widely held view that it will appreciate significantly from current levels,” Arone writes in a paper, titled Uncommon Sense: A Contrarian View on the Dollar. “The recent, strong run-up in the currency’s value is a cyclical phenomenon, not a secular upturn, and as it starts to play itself out I am concerned some investors may get caught chasing performance.”

By contrast, a survey of hedge fund managers from Aksia found that 86% of managers polled expect the U.S. dollar to be the top performing currency in 2015.

While the U.S. dollar index is up 23% from its 2011 low, Arone wonders if the U.S. dollar’s strength will endure. He predicts the dollar rally may take a breather.

“I believe predicting currency fluctuations is a fool’s errand, but we do see incredibly lopsided sentiment on the U.S. dollar after its strong run,” he says. “When everyone is expecting something to happen, the consensus is often wrong. So, is now a good time to begin hedging on hedging?”

Arone looks at past strong dollar movements in the 1980s and 1990s — when U.S. dollar strength did endure — and compares them to today.

“The two big late-20th century upward moves in the dollar came in times of robust U.S. economic growth and relatively tight monetary policy,” he write. “Neither condition exists today.”

According to Arone, the estimates for first quarter gross domestic product were significantly reduced because of severe winter weather in the Northeast, port shutdowns from dockworker strikes on the West Coast and mixed economic data. Meanwhile, a weak March jobs report combined with benign inflation and lackluster wage growth had “many a market pundit calling for the Fed to remain lower for longer,” Arone says.

A strong dollar may not be all it’s cracked up to be; as Arone points out, it creates particular headaches for U.S. investors in foreign assets. “When the U.S. dollar strengthens against its currency rivals, it has a negative impact on international stocks and bonds that are converted back to dollars,” he writes. Adding, “If the dollar’s strength pauses or even reverses, it would give some much-needed relief to U.S. investors in international stocks.”

Up until the last few years, international equities often represented a tiny portion of equity assets held by U.S. investors. But, today, more U.S. investors are buying international stocks than ever before.

In particular, investors seem interested in packaged strategies that hedge out the movement of foreign currencies, especially currency-hedged exchange-traded funds.

Currency-hedged ETFs brought in more than $20 billion of inflows. According to Arone, one out of every three new dollars invested in U.S.-listed ETFs in the first quarter went to currency-hedged ETFs. According to, four of the 10 most popular ETFs in the first quarter were currency-hedged.

“The inflows of currency-hedged ETFs is indicative of investor bullishness on the dollar,” Arone says.

But, he says, he is concerned some investors may get caught chasing performance.

“It’s important to remember that currency hedging can taketh away as well as giveth,” he writes. “If you’re in a currency-hedged ETF and the dollar starts moving in the other direction against that particular currency, that could actually start eating into returns.”

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