The U.S. dollar has reasserted itself on the global stage after a long absence. Since July it's been on a tear, with the U.S. Dollar Index now some 7.7% higher than where it was this summer.  The dollar has tended to be strong on days when macro data has been weak, buoyed by flight to quality flows and away from emerging markets.  On days when markets are up on good news the dollar often rallies too, on the view that the U.S. is finally poised for a self-sustaining economic recovery and will outperform other developed markets.

Speaking with traders, the dollar’s upward movement has long been widely anticipated.  The strong dollar narrative, which has recently translated into a clear price trend, appears to be boosted by sound fundamental underpinnings.  Though macroeconomic data is noisy, the preponderance of data seems to show that the US economy is slowly but surely getting stronger.  Consumer deleveraging seems to be near completion, corporate profits are near record highs, and the unemployment rate is now under 6%.

While the picture is improving in the US, the rest of the world's economies appear to be experiencing various forms of economic malaise. Deflation fears in Europe, challenging demographics for growth in Japan, and overcapacity and oversupply in many commodities critical to emerging markets have led to weak economic outlooks and accommodative monetary policy in most of the world.  The monetary policy response in the US versus the rest of the world is expected to become even starker, with expected increases in US rates offering relatively higher real returns to investors.  Investor flows should follow higher real yields and boost the dollar. Meanwhile, the energy boom in the US will keep the US trade account balance supportive of the dollar.

How to Play Dollar Strength

The investment implication of a strong dollar is less straightforward than the narrative.  One can't simply buy the dollar like any other asset. In currencies, you have to sell something to own something else.  So when one looks to buy the dollar the inevitable question is: against what?  This is where the dollar trend gets interesting because lately the dollar has been showing strength against almost all currency trading blocks.

Against other large developed market currencies like the Euro (EUR) and the Yen (JPY), the dollar strength has been driven by the expected divergence in monetary policy and, more specifically, differences in front-end yield curves.  Fed actions are expected to result in higher rates at some point next year. In contrast, the European Central Bank and the Bank of Japan are expected to increase stimulus programs, with the prospect of increasing interest rates still very far off. Differences in yield between the US and Japan should drive investor flows.  The macro-economic underpinnings to the trade seem unlikely to change over the short term, making the Yen and Euro favorite picks amongst traders for funding dollar longs.

In emerging markets (EM) the drivers of dollar strength are somewhat similar to those in developed markets, but with a subtle twist.  Relative yields can still drive marginal investor flows, but funding concerns in EM can exacerbate these swings.  Following the 2008 financial crisis, many EM countries witnessed large foreign investor inflows, significant expansion in local credit markets, and substantial increases in economic capacity. In many places this has led to over-investment and subsequent lower returns on capital.  Meanwhile, an expansion of credit over the past several years has led to high property prices, leveraged balance sheets, and in some cases an over-reliance on credit from external sources.  As front-end and potentially even mid-curve yields move higher in the US, some of these currencies may be vulnerable to more dramatic shifts in investor flows.  The Brazilian Real (BRL), Turkish Lira (TRY), Indonesian Rupiah (IDR), and South African Rand (ZAR) all experienced this effect earlier this year and last summer and may again soon.

Meanwhile, commodity block currencies have also been weakening against the dollar.  This has less to do with front-end yield differentials than it does with trade balance mechanics.  As U.S. energy production has soared, energy prices have remained low and recently have been falling.  Commodity producing currencies like the Australian dollar (AUD), New Zealand dollar (NZD), Norwegian krone (NOK), and the Canadian dollar (CAD) typically receive a strong and persistent boost from their commodity export activity.

Commodity markets operate in dollars.  As these countries trade metal/oil for dollars, they need to convert those dollars (selling them) back into their local currency (buying it) in order to meet local liabilities (pay their staff).  Lower commodity prices and lower demand due to economic stagnation in the rest of the world has caused commodities to trade at lower volumes and prices.  Thus, the dollar strength in these countries appears to be primarily driven by supply/demand dynamics for commodities.

One key implication of dollar strength for investors and institutional allocators in particular, is currency hedging programs may need to change.  Over the past decade or two, a large constituency of US institutional investors has shifted from a traditional 60/40 US equity and bond mix to incorporating foreign equity and debt.  While the dollar was in a multi-year depreciation trend, many foreign investments were left unhedged against the dollar as this provided a nice tailwind to returns. However, in light of a potential regime shift to dollar strength, investors should now be combing through their foreign holdings and closely evaluating whether or not any of these long-standing hedging decisions should be revisited.

Outside of FX, it’s hard to make strong linkages between dollar price strength and asset class moves.  Zero interest rate policy (ZIRP) in the US has pushed investors on a multi-year search for yield into some corners of the world that are well off the beaten path.  If rates in the ten year sector and beyond do indeed begin to move in the US, overbought debt, including certain EM companies and sovereigns, will likely be in the crosshairs of investor selling.  Even in the US, any high dollar-priced debt with a high duration component seems potentially vulnerable.

The implication for U.S. equities is unclear. During the late 1990’s the US experienced a multi-year economic expansion which drove a sustained equity rally and also led to a stronger dollar. In recent years the weak dollar and strong equity performance has been driven, at least in part, by easy monetary policy.  Absent that policy, we've seen dollar strength, but will we see equity weakness? The answer will really depend on whether or not growth is strong enough to translate into higher earnings for US equities.

Complicating this picture are the low growth prospects for the rest of the world. Foreign sales now account for a little less than half of sales for S&P 500 companies.  Additionally, revenues earned overseas may now begin to appear lower when converted back to dollars simply because the dollar is moving higher.  Earnings may be missed as a result and sectors like IT, Materials, and Energy tend to show the most vulnerability to dollar strength.  The key question is whether the benefits of US growth can overcome the negative effects of a stronger dollar on earnings for US companies.

Is this Already Priced In?

The recent dollar move has been so stark and sudden that there are fears that the dollar trend may be due for a pullback.  The greenback’s resurgence hasn't exactly gone unnoticed. Macro hedge funds posted some of their best gains of the year in September (HRFX Macro Index +1.54E%), as monetary policy divergence led to trends in FX (EURUSD -3.82%, JPYUSD -5.06%) and an uptick in fixed income volatility.  The strong dollar theme has a large fan-base.  Indeed, compared to recent history, the dollar long trade seems crowded, leading to unease on the potential for a pullback.

Perhaps some investors are uneasy because we simply haven't seen a multi-year secular strong dollar trend yet this century.  The last period where the dollar moved persistently higher for an extended period of time was in the late 1990's.  At that time, strong US growth led to hawkish Fed policy, leading to higher real rates for investors in the US relative to other markets.  However, over the past ten years, investors have been mostly rewarded for shorting the dollar and buying emerging market currencies as well as other currencies in G20.  Prior to 2013, even the Yen posted a steady multi-year climb against the dollar.

As one veteran trader recently put it to me, "Over the past ten years no one has really made money being long the dollar, but careers have been made being short."  The same veteran trader pointed out that, yes, the trade looks crowded based on recent history, when any strength in the dollar has typically been fleeting.  However, if this is indeed the beginning of a multi-year dollar strengthening trend, then what looks to be over-positioning on a tactical trade, may be under-positioning for a long-term secular shift.

The dollar strength narrative has begun to move markets in the past few months.  The economic underpinnings look as though they have the potential to create a multi-year secular trend.  Much will depend on whether the economic trajectory of the world's major economies stays on the current track: with the US improving and the rest of the world stagnating or deteriorating.