The Surprise of the Year – A Strong U.S. Dollar
By David Nelson, CFA
The strength of the U.S. Dollar may end up being the surprise of the year. Ever since the depths of the financial crisis investors feared that the Fed’s loose monetary policy and a $4.3 Trillion Dollar Balance Sheet would eventually decimate the dollar pushing inflation through the roof. So far inflation fears have proved unfounded leaving popular inflation hedges like Gold sitting at the low end of a 3 year trading band.
This can also be seen in the price action of (TIP) iShares Barclays TIPS Bond Fund. Treasury Inflation Protected Securities have been a favorite hiding place for bond investors. The TIPS breakdown has forced their removal from our tactical asset class Bullfinder Trading portfolios.
Fueling the dollar’s rise is the anticipation of a coming change in Fed policy and the relative economic strength here especially when compared to Europe. The Eurozone is on the brink of another recession and caught in the middle of a trade war with Russia as sanctions take their toll on both sides. Currency pricing is a relative exercise so weakness in the Euro and other currencies help prop up the Dollar.
Last Week’s Action
Alarm Bells could be heard across Wall Street trading desks as portfolio managers scrambled to deal with a rising Dollar and changing perception on Fed Policy. Adding to the confusion was a number of street economists turning 180 degrees now believing the FOMC will drop the key phrase “considerable time” as early as Wednesday.
The strong dollar dealt a crushing blow to energy stocks as both Brent and WTI crude touched 52 week lows. While the (XLE) SPDR Energy ETF is down less than 8% from highs earlier this year, some energy stocks like (ESV) Ensco and (OAS) Oasis Petroleum are off 15-20%.
The head fake started in June as the ISIS threat throughout the Middle East seemed to accelerate. Brent and Crude quickly pushed higher when ISIS soldiers advanced catching Iraqi troops and the U.S. off guard. No one fell for it more than yours truly having appeared on several networks calling for an energy spike as geopolitical fears mounted.
ISIS never made it into southern Iraq so the disruption never took hold and oil prices quickly retreated. The rising dollar along with enormous strides in U.S. production has blunted the impact.
A relative performance chart comparing the US Dollar Currency Index to Brent Crude spells it out perfectly. As the Dollar took off in July oil headed south, now sitting at 52 week lows.
Good News for U.S. Consumers
The drop in oil is starting to take hold at the pump. Falling gas prices are welcome news for retailers as it puts more discretionary dollars into the pockets of consumers.
A stronger currency isn’t all good news. Many of our largest most successful companies derive a significant portion of their revenue overseas. The currency translation can hit the top and bottom line forcing U.S. Multinationals to hedge their exposure which of course costs money.
Long Term Major Breakout?
A long term chart of the US. Dollar shows our currency on the edge of a major breakout with little resistance if it occurs. Wednesday’s Fed release followed by Chair Yellen’s press conference could prove key. If the change in language occurs and the Fed removes the phrase “considerable time” rates should rise and the dollar should continue its ascent.
Avoiding the Stampede
Asset managers need answers to the following questions:
- Will the U.S. Dollar continue to strengthen breaking a downtrend in place for more than a decade?
- Is the Fed about to move up their time table for an eventual Fed hike?
The answer to both these questions has enormous impact on sector allocations. Once the herd gets a whiff of change the stampede can wipe out those too slow to react. I can’t be sure but I believe the street is currently not prepared for either of these outcomes and is only now starting to make changes.
Death Blow for Putin?
A continued rise in the U.S. Dollar (DXY) will spell trouble for President Putin’s ambition to return Russia to its former status. The Russian economy is dominated by energy exports and would be hurt by falling energy prices. Russia has a long history of doing the illogical and for now seems willing to follow the course set by their leader whose popularity is incredibly high. This could change quickly if oil continues to fall.
So far our markets have been able to shake off any number of events from the removal of QE to geopolitical threats in virtually every corner of the world. In the end it’s going to come down to earnings which still look to be about $117 and $128 this year and next for the S&P 500, giving us about 9% growth. Investors hate change and if the trends laid out above continue, we should expect a period of adjustment that at times could turn violent.
At this point almost everyone has turned bullish and for now the data seems to support that view. In the last few weeks I’ve seen a parade of talking heads some pointing to a bull market that continues to 2020. My crystal ball isn’t quite that clear. I’m happy if I can see out till the end of December.
Charts were created on Reuters and StockCharts.com