The Independent Market Observer

Where Does the U.S. Dollar Go from Here?

Posted by Peter Essele, CFA®, CAIA, CFP®

This entry was posted on Dec 23, 2015 12:05:09 PM

and tagged Investing

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U.S. dollar

As many of you know, one of the most popular trades for investors in 2015 was a hedging of the U.S. dollar for international exposures—the overriding assumption being that the dollar would continue to increase following a hike in interest rates. 

The reasoning behind this is that higher interest rates, coupled with an expanding economy, should attract foreign capital to the U.S., resulting in a demand for dollars relative to other currencies. Further, an imbalance of supply and demand should result in an increase in the value of the dollar, which would detract from the returns offered by international investments for a domestic investor. The simple solution, therefore, is to hedge all international exposures in an effort to avoid the translation losses from foreign currencies back to the dollar in an environment where the dollar is appreciating.

Monthly asset flows into strategy tracking the MSCI EAFE Index

The popularity of this trade is evidenced by flows into strategies tracking the MSCI EAFE hedged index.

As the chart below shows, monthly asset flows into this strategy peaked in April after the very strong appreciation of the dollar in the latter part of 2014 and the first few months of 2015, as investor concern over an appreciating dollar hit multiyear highs. Following this strong influx of assets, however, the dollar index declined and has spent much of the year range-bound at a level lower than that reached in the early part of the year.

Monthly dollar flows into strategy tracking MSCI EAFE hedged index
U.S. dollar
Source: Morningstar® Direct

Should investors expect an appreciation of the dollar?

For the first time in almost a decade, last week the Federal Reserve (Fed) hiked the interbank lending rate by 25 basis points, as was well documented in previous posts. Following the announcement, the dollar has remained flat. This begs the question: Why aren’t we witnessing an appreciation of the dollar?

To help answer this, let’s explore the historical relationship between the dollar and interest rate hikes. In looking at the last three Fed tightening cycles, there is no evidence to suggest that the dollar appreciates in the days following the initiation of hikes. As shown in the chart below, in all three cases, the value of the dollar on a trade-weighted basis actually declined in the 12 months after the initiation of a rate hike.

U.S. dollar

Why does the dollar decline?

Much like other investable markets, currency exchange markets are forward looking, and the notion of “buy the rumor/sell the news” is very much at play. To illustrate this point, let’s first turn to the fixed income market, specifically the two-year U.S. Treasury yield. Leading up to the Fed hike, the prevailing feeling by many investors regarding fixed income was that any increase in the Fed funds rate would send ripples through the bond markets and result in declines in fixed income.

What many investors failed to realize, however, is that similar to currency exchange markets, fixed income markets are forward looking, so any well-documented move by the Fed would have little to no impact on the markets themselves. As the chart below shows, the two-year Treasury yield experienced a majority of its move this year in October and November—rather than in the days following the actual increase—and currency markets are no different.

U.S. dollar

Final thoughts

In my view, the appreciation of the dollar has already occurred for this rate cycle, and any further appreciation against a broad-based basket of currencies would be the result of exogenous factors other than those mentioned at the beginning of the post.

If you’d like additional commentary on this subject, feel free to contact me to continue the discussion.

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The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.

The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.

One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.

The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.

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